S-1 1 d575134ds1.htm S-1 S-1
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As filed with the Securities and Exchange Commission on June 19, 2018

Registration No. 333-            

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

 

 

FORM S-1

REGISTRATION STATEMENT

UNDER

THE SECURITIES ACT OF 1933

 

 

Coastal Financial Corporation

(Exact name of registrant as specified in its charter)

 

 

 

Washington   6022   56-2392007

State or other jurisdiction of

incorporation or organization

 

(Primary Standard Industrial

Classification Code Number)

 

(IRS Employer

Identification No.)

5415 Evergreen Way

Everett, Washington 98203

(425) 257-9000

(Address, including zip code, and telephone number, including area code, of registrant’s principal executive offices)

 

 

Eric M. Sprink

President and Chief Executive Officer

Coastal Financial Corporation

5415 Evergreen Way

Everett, Washington 98203

(425) 257-9000

(Name, address, including zip code, and telephone number, including area code, of agent for service)

 

 

Copies to:

 

  Frank M. Conner III, Esq.
  Michael P. Reed, Esq.
Aaron M. Kaslow, Esq.   Christopher J. DeCresce, Esq.
Stephen F. Donahoe, Esq.   Covington & Burling LLP
Kilpatrick Townsend & Stockton LLP   One CityCenter
607 14th Street, NW, Suite 900   850 Tenth Street, NW
Washington, DC 20005   Washington, DC 20001
Telephone: (202) 508-5800   Telephone: (202) 662-6000
Facsimile (202) 204-5600   Facsimile: (202) 662-6291

 

 

Approximate date of commencement of proposed sale to the public: As soon as practicable after this Registration Statement becomes effective.

If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box.  ☐

If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ☐

If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ☐

If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer      Accelerated filer  
Non-accelerated filer   ☒  (Do not check if a smaller reporting company)    Smaller reporting company  
     Emerging growth company  

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 7(a)(2)(B) of the Securities Act.  ☒

 

 

Calculation of Registration Fee

 

 

Title of each class of

securities to be registered

 

Proposed

maximum

aggregate

offering price(1)(2)

  Amount of
registration fee

Common Stock, no par value

  $30,000,000.00   $3,735

 

 

(1) Includes the aggregate offering price of additional shares of common stock that the underwriters have the option to purchase from the Registrant.
(2) Estimated solely for the purpose of calculating the registration fee in accordance with Regulation 457(o) under the Securities Act of 1933, as amended.

 

 

The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until the Registration Statement shall become effective on such date as the Commission, acting pursuant to Section 8(a), may determine.

 

 

 


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The information in this preliminary prospectus is not complete and may be changed. We may not sell these securities or accept any offer to buy these securities until the registration statement filed with the Securities and Exchange Commission is declared effective. This preliminary prospectus is not an offer to sell these securities and we are not soliciting an offer to buy these securities in any jurisdiction where the offer or sale is not permitted.

 

SUBJECT TO COMPLETION, DATED JUNE 19, 2018

 

 

PRELIMINARY PROSPECTUS

 

 

 

 

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             Shares

Common Stock

 

 

 

This is the initial public offering of shares of common stock of Coastal Financial Corporation, the bank holding company for Coastal Community Bank, a Washington state chartered bank. We are offering              shares of our common stock and the selling shareholders identified in this prospectus are offering              shares of our common stock. We will not receive any proceeds from the sale of shares of our common stock by the selling shareholders.

Prior to this offering, there has been no established public trading market for our common stock. We currently estimate that the initial public offering price of our common stock will be between $            and $            per share. We have applied to list our common stock on the Nasdaq Global Select Market under the symbol “CCB.”

 

 

Investing in our common stock involves risks. See “Risk Factors” beginning on page 18.

 

 

We are an “emerging growth company” as defined in the Jumpstart Our Business Startups Act of 2012 and will be subject to reduced public company reporting requirements. See “Implications of Being an Emerging Growth Company.”

 

     Per Share        Total  

Initial public offering price

    $        $                   

Underwriting discounts (1)

    $        $  

Proceeds, before expenses, to us

    $        $  

Proceeds, before expenses, to the selling shareholders

    $        $  

 

(1) See “Underwriting (Conflicts of Interest)” for additional information regarding underwriting compensation.

We have granted the underwriters an option to purchase up to            additional shares of our common stock at the initial public offering price, less the underwriting discounts, within 30 days after the date of this prospectus.

 

 

Neither the Securities and Exchange Commission nor any state securities commission or other regulatory body has approved or disapproved of these securities or passed upon the accuracy or adequacy of this prospectus. Any representation to the contrary is a criminal offense.

 

 

Our common stock is not a deposit or savings account of our bank subsidiary and is not insured by the Federal Deposit Insurance Corporation or any other governmental agency or instrumentality.

The underwriters expect to deliver the shares of our common stock to purchasers on or about                 , 2018, subject to customary closing conditions.

 

 

Joint Book-Running Managers

 

Keefe, Bruyette & Woods

A Stifel Company                         

   Hovde Group, LLC

The date of this prospectus is                    , 2018


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Dedicated to community banking 2017 & 2016 Recipient of the prestigious “5-Star Rating” from BauerFinancial, Inc. Everett Herald — 2014, 2015, 2016 and 2017 Readers Choice — “Best Bank” Plus... “2016 Best Financial Provider, Best Mortgage Lender and Best Place to Work” Stanwood & Camano News “Best Bank” (5 years in a row) 2013 * 2014 * 2015 * 2016 * 2017 “2017 & 2016 SBA Community Lender of the Year Award” in some of Washington’s most attractive markets


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TABLE OF CONTENTS

 

     Page  

PROSPECTUS SUMMARY

     1  

SELECTED HISTORICAL CONSOLIDATED FINANCIAL DATA

     14  

GAAP RECONCILIATION AND MANAGEMENT EXPLANATION OF NON-GAAP FINANCIAL MEASURES

     17  

RISK FACTORS

     18  

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

     42  

USE OF PROCEEDS

     44  

DIVIDEND POLICY

     45  

CAPITALIZATION

     46  

DILUTION

     48  

PRICE RANGE OF OUR COMMON STOCK

     50  

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     51  

BUSINESS

     85  

SUPERVISION AND REGULATION

     98  

MANAGEMENT

     111  

EXECUTIVE COMPENSATION

     119  

PRINCIPAL AND SELLING SHAREHOLDERS

     130  

CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS

     133  

DESCRIPTION OF CAPITAL STOCK

     136  

SHARES ELIGIBLE FOR FUTURE SALE

     142  

MATERIAL U.S. FEDERAL TAX CONSIDERATIONS FOR NON-U.S. HOLDERS OF OUR COMMON STOCK

     144  

UNDERWRITING (CONFLICTS OF INTEREST)

     148  

LEGAL MATTERS

     154  

EXPERTS

     154  

WHERE YOU CAN FIND MORE INFORMATION

     154  

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

     F-1  

 

 

About This Prospectus

You should rely only on the information contained in this prospectus or in any free writing prospectus that we authorize to be delivered to you. We, the selling shareholders and the underwriters have not authorized anyone to provide you with different or additional information. If anyone provides you with different or additional information, you should not rely on it. This prospectus relates to an offer to sell only the securities offered hereby, and only under circumstances and in jurisdictions where it is lawful to do so. We, the selling shareholders and the underwriters are not making an offer of these securities in any jurisdiction where the offer is not permitted. You should not assume that the information contained in this prospectus or any free writing prospectus is accurate as of any date other than the date of the applicable document, regardless of its time of delivery or the time of any sales of our common stock. Our business, financial condition, results of operations and prospects may have changed since that date.

Unless we state otherwise or the context otherwise requires, references in this prospectus to “we,” “our,” “us” or “the Company” refer to Coastal Financial Corporation, a Washington corporation, and our consolidated subsidiary, and references to “Coastal Community Bank” or “the Bank” refer to our banking subsidiary, Coastal Community Bank, a Washington state chartered bank.

Unless otherwise indicated, references in this prospectus to “common stock” refer to our voting common stock, no par value per share, and references to “nonvoting common stock” include our Class B Nonvoting

 

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Common Stock, no par value per share, and our Class C Nonvoting Common Stock, no par value per share. References to our “common shares” include our common stock and nonvoting common stock. Per share amounts presented in this prospectus are based on total common shares outstanding. No shares of our nonvoting common stock are offered hereby.

References in this prospectus to the “Seattle MSA” refer to the Seattle-Tacoma-Bellevue, Washington metropolitan statistical area. References to the “Puget Sound region” refer to the Seattle MSA along with the adjacent metropolitan areas of Olympia, Bremerton and Mount Vernon, as well as Island County.

Unless otherwise stated, all information in this prospectus assumes that the underwriters do not exercise their option to purchase additional shares of our common stock and gives effect to a one-for-five reverse stock split of both our common stock and nonvoting common stock completed effective May 4, 2018. The effect of the reverse stock split on outstanding shares and per share figures has been retroactively applied to all periods presented in this prospectus.

Any discrepancies included in this prospectus between totals and the sums of the percentages and dollar amounts presented are due to rounding.

You should not interpret the contents of this prospectus or any free writing prospectus that we authorize to be delivered to you to be legal, business, investment or tax advice. You should consult with your own advisors for that type of advice and consult with them about the legal, tax, business, financial and other issues that you should consider before investing in our common stock.

Market and Industry Data

Within this prospectus, we reference certain industry and sector information and statistics. We have obtained this information and statistics from various independent, third-party sources. Nothing in the data used or derived from third-party sources should be construed as advice. Some data and other information are also based on our good faith estimates, which are derived from our review of internal surveys and third-party sources. We believe that these third-party sources and estimates are reliable, but have not independently verified them. Statements as to our market position are based on market data currently available to us. Although we are not aware of any misstatements regarding the demographic, economic, employment, industry and market data presented herein, these estimates involve inherent risks and uncertainties and are based on assumptions that are subject to change. See “Risk Factors.”

Trademarks referred to in this prospectus are the property of their respective owners, although for presentational convenience we may not use the ® or the ™ symbols to identify such trademarks.

Implications of Being an Emerging Growth Company

We are an “emerging growth company” under the Jumpstart Our Business Startups Act of 2012, or the JOBS Act. An emerging growth company may take advantage of reduced reporting requirements and is relieved of certain other significant requirements that are otherwise generally applicable to public companies. As an emerging growth company:

 

    we may present as few as two years of audited financial statements and as few as two years of related management’s discussion and analysis of financial condition and results of operations;

 

    we are exempt from the requirement to obtain an attestation report from our auditors on management’s assessment of the effectiveness of our internal control over financial reporting under the Sarbanes-Oxley Act of 2002, or the Sarbanes-Oxley Act;

 

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    we may choose not to comply with any new requirements adopted by the Public Company Accounting Oversight Board requiring mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and our financial statements;

 

    we are permitted to provide reduced disclosure regarding our executive compensation arrangements pursuant to the rules applicable to smaller reporting companies, which means we do not have to include a compensation discussion and analysis and certain other disclosures regarding our executive compensation; and

 

    we are not required to give our shareholders non-binding advisory votes on executive compensation or golden parachute arrangements.

We will cease to be an “emerging growth company” upon the earliest of:

 

    the last day of the fiscal year in which we have total annual gross revenues of $1.07 billion or more;

 

    the date on which we become a “large accelerated filer” (the fiscal year end on which the total market value of our common equity securities held by non-affiliates is $700 million or more as of June 30);

 

    the date on which we have, during the previous three-year period, issued more than $1.0 billion in non-convertible debt; and

 

    the last day of the fiscal year following the fifth anniversary of the completion of this offering.

We have elected to adopt the reduced disclosure requirements above for purposes of the registration statement of which this prospectus forms a part. In addition, we expect to take advantage of certain of the reduced reporting and other requirements of the JOBS Act with respect to the periodic reports we will file with the Securities and Exchange Commission, or the SEC, and proxy statements that we use to solicit proxies from our shareholders.

In addition, Section 107 of the JOBS Act permits us to take advantage of an extended transition period for complying with new or revised accounting standards affecting public companies. However, we have irrevocably opted out of the extended transition period and, as a result, we will adopt new or revised accounting standards on the relevant dates on which adoption of such standards is required for other public companies.

 

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PROSPECTUS SUMMARY

This summary highlights selected information contained elsewhere in this prospectus and may not contain all the information you should consider before investing in our common stock. Before making a decision to purchase our common stock, you should read the entire prospectus carefully, including the sections entitled “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Cautionary Note Regarding Forward-Looking Statements,” together with our consolidated financial statements and the related notes to those financial statements that are included elsewhere in this prospectus. Except as otherwise noted, all information in this prospectus assumes that the underwriters do not exercise their option to purchase additional shares of our common stock and gives effect to a one-for-five reverse stock split of our common shares completed effective May 4, 2018. The effect of the reverse stock split on outstanding shares and per share figures has been retroactively applied to all periods presented in this prospectus.

Our Company

We are a bank holding company that operates through our wholly owned subsidiary, Coastal Community Bank. We are headquartered in Everett, Washington, which by population is the largest city in, and the county seat of, Snohomish County. We focus on providing a wide range of banking products and services to consumers and small to medium sized businesses in the broader Puget Sound region in the state of Washington. We believe that the size, growth and economic strength of the Puget Sound region provide us with significant opportunities for long-term growth and profitability. We currently operate 13 full-service banking locations, 10 of which are located in Snohomish County, where we are the largest community bank by deposit market share, and three of which are located in neighboring counties (one in King County and two in Island County). As of March 31, 2018, we had total assets of $831.0 million, total loans of $678.5 million, total deposits of $727.3 million and total shareholders’ equity of $66.9 million.

Our History and Growth

We are a Washington corporation that was formed on July 9, 2003, to become the holding company for Coastal Community Bank, which commenced operations in 1997 and to which we refer in this prospectus as the Bank. The Bank was formed by local business leaders who recognized the opportunity to create a bank that could meet the financial needs of the community, make decisions locally and support the communities it serves.

We have focused on achieving our growth organically, without engaging in mergers or branch acquisitions. Our net income and earnings per share for the three months ended March 31, 2018, were $1.8 million and $0.20, respectively. Including the negative impact of P.L. 115-97, commonly known as the Tax Cuts and Jobs Act, on our earnings in 2017, our net income and earnings per share for fiscal year 2017 were $5.4 million and $0.59, respectively. The following tables illustrate our income and balance sheet growth as of or for the quarter ended March 31, 2018, and the quarter ended March 31, 2017 (with respect to adjusted net income and adjusted earnings per share), and the years ended December 31, 2017, 2016, 2015, 2014 and 2013. (Dollars in millions except per share amounts.)



 

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Adjusted Net Income (1)    Adjusted Earnings Per Share (1)

 

 

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Total Assets    Total Loans

 

 

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Total Deposits    Core Deposits (2)

 

 

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(1) Adjusted net income and adjusted earnings per share for the year ended December 31, 2017, exclude the impact of the revaluation of our deferred tax assets as a result of the reduction in the corporate income tax rate as a result of the Tax Cuts and Jobs Act. See our reconciliation of non-GAAP financial measures to our most directly comparable GAAP financial measures in the section entitled “GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures.” See also “Selected Historical Consolidated Financial Data.”
(2) We define core deposits more narrowly than many other banks and institutional data services. For us, core deposits consist of total deposits less all time deposits.


 

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Competitive Strengths

We believe the following strengths differentiate us from our competitors and position us to execute our business strategy successfully:

Premier local bank in the Puget Sound region. We are the largest locally headquartered bank in Snohomish County, measured by deposit market share. Our success has made us attractive to lenders who prefer to work in a community bank setting and customers who seek the personal attention of a community bank. As further described in “Our Markets” below, we believe that our primary market, the Puget Sound region, which is located in northwest Washington, provides us with an advantage over other community banks in Washington in terms of growing our loans and deposits, as well as increasing profitability and building shareholder value. The net proceeds of this offering to us will enable us to serve larger customers through higher legal lending limits. Additionally, having publicly traded common stock will further enhance our ability to attract and retain talented bankers. We intend to continue expanding our physical presence in Snohomish and neighboring counties and believe we can continue to increase our market share in the Puget Sound region and surrounding counties.

Attractive core deposit franchise. We have a valuable deposit franchise supported by a substantial level of core deposits, which we define as total deposits less all time deposits, and a high level of noninterest bearing accounts. As of March 31, 2018, core deposits comprised 87.7% of total deposits and 94.0% of total loans, while noninterest bearing core deposits comprised 34.9% of total deposits, up from 30.6% at December 31, 2013. None of our deposits were brokered or internet-sourced deposits at March 31, 2018. Our core deposit base results from our emphasis on banking relationships over transactional banking. We believe that our robust core deposit generation is powered by our strong personal service, visibility in our communities, broad commercial banking and treasury management product offerings, and convenient services such as remote deposit capture and commercial internet banking. We also employ deposit-focused business development officers to generate deposit relationships.

The following table illustrates the improvement of our core deposit base as a percent of total deposits and as a percent of total loans:

 

Balance Sheet Funded by Core Deposits (Total Deposits Less Time Deposits)

 

 

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Scalable operating model. We have invested in employees and infrastructure to enhance and expand our capabilities and support the growth of our franchise. In particular, we strive to adopt the latest technology to better serve our customer base and improve our operational efficiency. These investments include increasing staffing of our credit administration, finance and information technology departments and developing a full range of commercial and consumer banking services. We offer our retail customers internet and mobile banking with peer-to-peer payments. We offer our commercial customers internet banking, remote deposit capture and online treasury management tools. In addition, we use online tools to streamline the origination of small commercial loans. We believe these investments will support our future growth in a cost-effective manner. Our investments in technology and infrastructure have provided us with a scalable operating platform and organizational infrastructure that will allow us to continue to improve our operating leverage and continue our growth without significant investments in the near term.

Experienced senior management team. Our leadership team consists of experienced banking executives with strong ties to our markets, many of whom have experience working at larger financial institutions.

 

    Eric M. Sprink, our President and Chief Executive Officer, has over 27 years of experience in the financial services industry, including 12 years in the Puget Sound region. Prior to joining the Company in 2006, Mr. Sprink held leadership positions with several financial institutions in corporate finance, retail banking, commercial lending, private banking and trust management.

 

    Joel G. Edwards, our Chief Financial Officer, has over 32 years of experience in the financial services industry, including 23 years in the Puget Sound region. He has served as chief financial officer for both privately held and publicly traded Washington banking institutions. Mr. Edwards joined the Company as Chief Financial Officer in 2012.

 

    Russ A. Keithley, our Chief Lending Officer, has over 28 years of experience in the financial services industry, all in the Puget Sound region. Prior to joining the Company in 2012, Mr. Keithley served as chief lending officer and chief credit officer at other financial institutions.

Diversified loan portfolio. We have an attractive loan mix, with 12.8% commercial and industrial, or C&I, loans, 24.9% owner-occupied commercial real estate, or CRE, loans, 32.8% non-owner-occupied CRE loans and 13.4% one- to four-family residential loans at March 31, 2018. Approximately 37.7% of our loan portfolio is comprised of owner-operated business loans, which includes C&I and owner-occupied CRE loans on a combined basis, and 48.6% of our portfolio consists of loans for investor-owned properties and projects, which includes non-owner-occupied CRE loans, multi-family loans and construction and land development loans on a combined basis. We believe that our knowledgeable and prudent approach to real estate lending results in relatively lower losses caused by defaults, as compared to other types of commercial lending.



 

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Well positioned for a rising rate environment. In anticipation of a rising rate environment, we have focused our business to emphasize the origination of floating-rate loans in our real estate loan portfolio and limited the number of long-term, fixed-rate loans. As of March 31, 2018, approximately 56.0% of our total loan portfolio had floating or adjustable interest rates. Additionally, we currently fund the majority of our loan portfolio with core deposits, which represented 94.0% of loans as of March 31, 2018, and which we believe will re-price more slowly than our assets. As of March 31, 2018, our one-year cumulative re-pricing gap to total assets of 25% was in the 78th percentile of banks nationwide, according to data obtained through S&P Global Market Intelligence, or S&P Global.

Disciplined underwriting and credit administration. Our management and credit administration team fosters a strong risk management culture supported by comprehensive policies and procedures for credit underwriting, funding, and loan administration and monitoring that we believe has enabled us to establish excellent credit quality. We monitor categories of lending activity within our portfolio and establish sub-limits that we review regularly and adjust in response to changes in our lending strategy and market conditions.



 

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The positive impact of our disciplined underwriting and credit administration is demonstrated in the graph below, which shows the decrease in our nonperforming assets and our charge-off history as of and for the three months ended March 31, 2018, and the twelve months ended December 31, 2017, 2016, 2015, 2014 and 2013.

 

 

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Our Business Strategy

We position ourselves as an attractive local community bank alternative to larger, more impersonal financial services companies. We believe that banking industry consolidation and branch rationalizations have led to an underserved base of small and medium sized businesses, many of which prefer to bank with a local financial institution with agile, highly responsive decision-making capabilities. Our management team’s experience and established presence in our market area gives us valuable insight into the local market, allowing us to recruit talented lenders and attract high-quality customer relationships. We seek to develop long-term relationships by offering a wide array of deposit and treasury products and services to complement our loan products and by delivering high-quality customer service.

The following is a more detailed description of our business strategy:

Strategically expand. We aim to continuously enhance our customer base, increase loans and deposits and expand our overall market share, and we believe that the Puget Sound region specifically has significant organic growth opportunities. We have pursued measured growth through strategic de novo branch expansion. In the last five years, we have added five branches: two in 2013, two in 2015 and one in 2017. As we identify attractive communities for expansion, we seek branch managers, lenders and business development officers prior to establishing a physical presence in any area. We intend to continue expanding our physical presence in Snohomish and neighboring counties when good opportunities that meet our requirements become available.

While acquisitions have not been a driver of our historic growth, we periodically evaluate opportunities to expand through strategic acquisitions. We believe there are several community banks that could be a natural fit for our franchise and could meaningfully enhance our value, and we follow a disciplined approach when evaluating any acquisition opportunities.

Organically grow our loan portfolio and lending staff. We have successfully expanded our loan portfolio by training and encouraging the growth of our junior lenders and by recruiting additional lenders in our existing and target markets. We believe we will benefit from our commitment to developing the next generation of talented lenders. We have created a culture in which our more seasoned lenders train their junior counterparts, enabling them to generate additional loan relationships as they mature in the business. Additionally, by actively involving junior lenders, our senior lenders gain additional flexibility to expand their own relationships. In addition to



 

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developing our junior lenders, we seek to hire additional seasoned lending teams. We believe we are an attractive destination for top talent because we offer a platform of sophisticated product and service capabilities as well as the freedom and flexibility to follow customers in our market area without imposing strict territorial limitations on our lenders. Additionally, we believe that having a marketable common stock as the result of this offering will assist us in recruiting talented personnel through our having the ability to offer the possibility of stock-based incentive compensation. We believe that our commitment to the development of our lenders will lead to long-term continuity in personnel and the recruitment and retention of high-quality lenders in our markets.

Fund growth through core deposits. We fund our loan growth primarily through customer deposits, as reflected by our ratios of core deposits to total deposits and core deposits to total loans of 87.7% and 94.0%, respectively, as of March 31, 2018. The strength of our deposit franchise results from our development and maintenance of long-standing customer relationships. Our relationship managers and branch managers actively seek deposit relationships with our loan customers. We also employ business development officers to generate these relationships. We attract deposits from our commercial customers by providing them with personal service, a broad suite of commercial banking and treasury management products and convenient services such as remote deposit capture and commercial internet banking.

Dedication to community banking. We attribute our success to our adherence to the basic principles of community banking: we know our markets and our customers, and we are meaningfully contributing members of our communities. Our employees volunteer with, serve on the boards of and contribute to dozens of local organizations, and, in 2017, we contributed the most volunteer hours per employee of the 75 companies ranked by the Puget Sound Business Journal. We empower our employees of all levels to make appropriate decisions on customer products and services. By creating expectations of high-quality service and enabling our employees to deliver that service, we believe we have created an environment that attracts both employees and customers.

Increase utilization of technology. We actively explore opportunities to use technology to improve efficiency, deliver superior service and drive growth without compromising our underwriting standards. We have installed cash recyclers in every branch, deployed automatic teller machines, automated portions of the origination process for commercial loans and implemented instant issuance of debit and credit cards. We also provide commercial internet banking, remote deposit capture and online treasury management tools, as well as mobile and internet banking and peer-to-peer payment capabilities. We work diligently to make banking easier for small business owners, enabling them to focus on their businesses. Additionally, we actively recognize and monitor the potential impacts that emerging technologies may have on the banking landscape. We periodically evaluate strategic partnerships with technology-focused companies that we believe will benefit our employees, customers and shareholders, generate additional fee income, enhance our product offerings, monitor our enterprise risk, or otherwise enable us to identify process or cost efficiencies.

Our Markets

We define our market broadly as the Puget Sound region in the state of Washington, which encompasses the Seattle MSA, the metropolitan areas of Olympia, Bremerton and Mount Vernon, and Island County. The Seattle MSA includes Snohomish County (which contains the city of Everett), King County (which contains the cities of Seattle and Bellevue) and Pierce County (which contains the city of Tacoma). The Puget Sound region, which comprises over 60% of the population of the state of Washington as well as the number of businesses located therein, according to data obtained through S&P Global, is a growing market, currently with a population of approximately 4.7 million, over 178,000 businesses and $115 billion of deposits. We believe that the Puget Sound region specifically has significant organic growth opportunities.



 

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The following table shows certain demographic information regarding our market area:

 

Market Area

  Number
of
Coastal

Branches
    Total
Deposits in
Market
($ in
millions)
    Population     Number
of

Businesses
    Median
Household
Income
($)
    April 2018
Unemployment
Rate
(% )
 
      2018
Estimated
    Growth        
        2013-2018     2018-2023        
        Estimated     Projected        

Puget Sound Region

               

Seattle-Tacoma-Bellevue MSA

    11     $  104,715       3,885,514       9.0     6.7     150,558     $ 82,186       3.6

King County (Seattle & Bellevue)

    1       81,779       2,198,918       9.7     7.0     96,918       90,281       3.0

Snohomish County (Everett)

    10       11,640       807,101       10.0     6.8     23,864       83,174       3.3

Pierce County (Tacoma)

    0       11,296       879,495       6.6     6.0     29,776       65,896       5.4

Olympia-Tumwater MSA

    0       3,539       282,330       8.0     6.5     11,709       66,766       5.0

Bremerton-Silverdale MSA

    0       3,046       270,215       3.6     5.0     10,443       72,338       5.0

Mount Vernon-Anacortes MSA

    0       2,466       126,007       5.1     5.1     5,639       60,361       5.4

Island County

    2       1,134       84,841       6.0     5.2     3,354       64,150       5.6

Total Puget Sound Region

    13     $ 114,900       4,648,907       8.5     6.6     181,703       -       -  

Sources: S&P Global and the U.S. Bureau of Labor Statistics.

We are the largest locally headquartered bank by deposit market share in Snohomish County, according to data from the Federal Deposit Insurance Corporation, or FDIC, as of June 30, 2017, at which date we had a five percent deposit market share in Snohomish County. We aim to continuously enhance our customer base, increase loans and deposits and expand our overall market share in Snohomish County. In light of our market position and our business strategy, we do not regularly compete for commercial or retail deposits in the city of Seattle, and we believe this strategic decision has enabled us to generate low cost core deposits to fund our loan growth.

The following table shows our market position in Snohomish County:

 

Institution (Headquarter State)

   Overall
Rank
     In-Market
HQ Rank
     Deposits in
Market
($ in millions)
     Number
of
Branches
     Deposit
Market
Share (%)
 

Bank of America Corp. (NC)

     1         $ 2,561        21        22.0

JPMorgan Chase & Co. (NY)

     2           1,757        25        15.1

Wells Fargo & Co. (CA)

     3           1,480        19        12.7

U.S. Bancorp (MN)

     4           710        12        6.1

KeyCorp (OH)

     5           583        18        5.0

Coastal Financial Corp. (WA)

     6        1        578        10        5.0

Union Bank of California (CA)

     7           545        8        4.7

Opus Bank (CA)

     8           438        6        3.8

Heritage Financial Corp. (WA)

     9           418        8        3.6

Washington Federal Inc. (WA)

     10           416        9        3.6
  

 

 

    

 

 

    

 

 

    

 

 

    

Total For Institutions In Market

     25        6      $ 11,640        180     

Note: Deposits are as of June 30, 2017, the most recent deposit data available from the FDIC.



 

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Snohomish County. Our headquarters are located in Everett, Washington, which is the largest city in, and the county seat of, Snohomish County with a population of approximately 113,000 as of January 1, 2018. Snohomish is the third largest county by population in the state of Washington, with an estimated population of approximately 800,000 as of January 1, 2018, and the second largest county by total deposits, with $11.6 billion in total deposits as of June 30, 2017, according to data obtained through S&P Global.

The Snohomish County economy is one of the strongest in the United States, boasting a rapidly growing population with a median annual household income of $83,174, the second highest in Washington and significantly above the national average, as of January 1, 2018, and a low unemployment rate of 3.3% as of April 2018. Snohomish has seen consistent growth in service-providing jobs, which account for more than 72% of the jobs in the county. Jobs related to trade, transportation and utilities, retail, and education and health services are the largest sub-categories of service-providing jobs. The Boeing Company, which employed 34,500 people in 2017, is the largest employer in Snohomish County. The second and third largest employers in Snohomish County, Providence Regional Medical Center and the Tulalip Tribes employed 4,775 and 3,200 full-time employees in 2017, respectively, and the U.S. Navy has a meaningful presence in Everett and was the fourth largest employer in Snohomish County in 2017. In addition, Paine Field in Everett will open to commercial air traffic in 2018, and Southwest Airlines, Alaska Airlines, and United Airlines have announced plans to add routes to and from Paine Field, primarily to and from cities in the western United States. We believe this development will lead to further population growth and increase economic development in Snohomish County.

Snohomish County is a large, addressable market with a lower cost of doing business relative to neighboring King County, which includes the cities of Seattle and Bellevue. Based on available data, we believe that a significant portion of the Snohomish County population consists of a mobile commuter work force with relatively easy access to nearby technology and industrial centers. Our location in Snohomish County enables us to have a lower cost structure and lower cost deposits, compared to banks in King County, while also providing us ready access to its larger economy.

King County. King County borders Snohomish County to the south and is the largest county by population in the state of Washington. It is the 13th largest county in the United States with an estimated population of 2.2 million and total deposits of $82 billion as of June 30, 2017, according to the FDIC’s Summary of Deposits. Additionally, the population growth of King County was the second fastest in Washington from 2013 to 2018. While we do not have significant physical presence in King County, our locations in Snohomish County enable us to take advantage of the abundant lending and business opportunities there.

King County, which contains the city of Seattle, boasts headquarters to 10 Fortune 500 companies, including Amazon, Costco, Microsoft and Starbucks. Additionally, 31 Fortune 500 companies currently operate research and engineering hubs in Seattle, as compared to seven companies in 2010, according to The Atlantic. Seattle has become a favored location for technology companies and, according to CBRE Group, Inc., is currently one of the top two tech markets in the United States, ranking behind only the San Francisco Bay Area.

Recent Developments

Reverse Stock Split

On May 4, 2018, we effected a one-for-five reverse stock split, whereby every five shares of our common stock and nonvoting common stock were automatically combined into one share of common stock and nonvoting common stock, respectively. Fractional shares were rounded up to the nearest whole share. Except for adjustments that resulted from the treatment of fractional shares, each shareholder held the same percentage of common stock or nonvoting common stock, as the case may be, outstanding after the reverse stock split as that shareholder held immediately prior to the reverse stock split. The effect of the reverse stock split on outstanding shares and per share figures has been retroactively applied to all periods presented in this prospectus.



 

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Banking Services Agreement with Aspiration Financial, LLC

On May 17, 2018, we entered into an agreement with Aspiration Financial, LLC, or Aspiration, an online investment platform that offers socially-conscious and sustainable banking and investing, pursuant to which we will provide certain banking services for Aspiration’s new cash management account program that Aspiration intends to launch in the third quarter of 2018. As part of our services to Aspiration, we will serve as the issuing bank for debit cards issued to Aspiration’s customers and we will establish one or more settlement accounts for the purpose of settling customer transactions in the Aspiration cash management account program. Substantially all of the Aspiration customer cash balances will be distributed to accounts at other depository institutions through a sweep network. We will retain a small portion of Aspiration customer cash balances for the purpose of facilitating settlement of payments and transfers. The agreement with Aspiration has an initial term of three years from the later of July 1, 2018 or the date on which Aspiration begins enrolling customers, and is subject to two automatic renewals for successive 12-month terms. Pursuant to the agreement with Aspiration, we will receive a quarterly fee based on the total deposits in the Aspiration cash management account program (and we must pay interest to Aspiration on the deposits we retain) and Aspiration will reimburse us for certain expenses.

Corporate Information

Our principal executive offices are located at 5415 Evergreen Way, Everett, WA. Our telephone number is (425) 257-9000. Our website is www.coastalbank.com. The information contained on or accessible from our website does not constitute a part of this prospectus and is not incorporated by reference herein.

Summary Risk Factors

Our business is subject to a number of substantial risks and uncertainties of which you should be aware before making a decision to invest in our common stock. These risks are discussed more fully in the section entitled “Risk Factors” beginning on page 18. Some of these risks include the following:

 

    credit risks, including risks related to the significance of commercial real estate loans in our portfolio, our ability to effectively manage our credit risk and the potential deterioration of the business and economic conditions in our market areas;

 

    liquidity and funding risks, including the risk that we will not be able to meet our obligations due to risks relating to our funding sources;

 

    operational, strategic and reputational risks, including the risk that we may not be able to implement our growth strategy and risks related to cybersecurity, the possible loss of key members of our senior leadership team and maintaining our reputation;

 

    legal, accounting and compliance risks, including risks related to the extensive state and federal regulation under which we operate and changes in such regulations;

 

    market and interest rate risks, including risks related to interest rate fluctuations and the monetary policies and regulations of the Board of Governors of the Federal Reserve System, or the Federal Reserve; and

 

    offering and investment risks, including illiquidity and volatility in the trading of our common stock, limitations on our ability to pay dividends and the dilution that investors in this offering will experience.


 

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THE OFFERING

 

Common stock offered by us

                shares

Common stock offered by the selling shareholders

                shares

Underwriters’ option to purchase additional
shares

  
We have granted the underwriters an option to purchase up to an additional shares of our common stock within 30 days after the date of this prospectus.

Common shares to be outstanding after this
offering

  
            shares, which includes common stock and nonvoting common stock (or             shares if the underwriters exercise in full their option to purchase additional shares of common stock)

Use of proceeds

   Assuming an initial public offering price of $             per share, which is the midpoint of the price range set forth on the cover page of this prospectus, we estimate that the net proceeds to us from this offering, after deducting estimated underwriting discounts but before payment of estimated offering expenses payable by us, will be approximately $             million (or approximately $             million if the underwriters exercise in full their option to purchase additional shares). We intend to use the net proceeds to us from this offering to support our growth, organically or through mergers and acquisitions, and for general corporate purposes, which may include the repayment or refinancing of debt and maintenance of our required regulatory capital levels. We will not receive any proceeds from the sale of shares of our common stock by the selling shareholders in this offering. See “Use of Proceeds.”

Dividends

   We have not historically declared or paid dividends on our common stock and we do not intend to pay cash dividends on our common stock in the near term. Instead, we anticipate that all of our future earnings will be retained to support our operations and finance the growth and development of our business. Our determination to pay dividends in the future will be at the discretion of our board of directors and will depend upon a number of factors, including our earnings, financial condition, results of operations, capital requirements, regulatory restrictions, and other factors that our board of directors may deem relevant. See “Dividend Policy.”

Investment Agreements

   Prior to this offering, we entered into Investment Agreements with certain of our shareholders that hold 4.9% or more of our outstanding common stock. Among other things, the Investment


 

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   Agreements provide such shareholders with certain board representation rights. For a detailed description of the Investment Agreements, see “Certain Relationships and Related Party Transactions—Certain Related Party Transactions—Investment Agreements.”

Proposed Nasdaq symbol

   We have applied to list our common stock on the Nasdaq Global Select Market under the symbol “CCB.”

Conflicts of interest

   An affiliate of Hovde Group, LLC, or Hovde Group, an underwriter in this offering, beneficially owns more than 10% of our issued and outstanding common stock. As a result, Hovde Group is deemed to have a “conflict of interest” within the meaning of Rule 5121 of the Financial Industry Regulatory Authority, Inc., or FINRA. Accordingly, this offering will be conducted in compliance with the applicable requirements of Rule 5121, which include, among other things, that a “qualified independent underwriter” as defined in Rule 5121 participate in the preparation of, and exercise the usual standards of due diligence with respect to, this prospectus and the registration statement of which this prospectus forms a part. Keefe, Bruyette & Woods, Inc., or Keefe, Bruyette & Woods, has agreed to act as a qualified independent underwriter for this offering. Keefe, Bruyette & Woods will not receive any additional compensation for serving as qualified independent underwriter in connection with this offering. See “Underwriting (Conflicts of Interest)—Conflicts of Interest.”

Directed share program

   At our request, the underwriters have reserved for sale, at the initial public offering price, up to 5% of the shares of our common stock offered in this offering for sale to certain of our directors, executive officers, employees and other related persons who have expressed an interest in purchasing our shares of common stock in this offering through a directed share program. We do not know if these persons will choose to purchase all or any portion of the reserved shares, but any purchases they do make will reduce the number of shares available to the general public. See “Underwriting (Conflicts of Interest)—Directed Share Program” for additional information.

Risk factors

   Investing in our common stock involves certain risks. See “Risk Factors,” beginning on page 18, for a discussion of factors that you should carefully consider before investing in our common stock.


 

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Except as otherwise indicated, references in this prospectus to the number of our common shares outstanding after this offering are based on 8,891,859 of shares of common stock and 361,444 shares of nonvoting common stock outstanding as of March 31, 2018. Except as otherwise indicated, all information in this prospectus:

 

    gives effect to a one-for-five reverse stock split of our common shares completed effective May 4, 2018;

 

    does not attribute to any director, executive officer or principal shareholder any purchase of shares of our common stock in this offering, including through the directed share program described in “Underwriting (Conflicts of Interest)—Directed Share Program;”

 

    assumes no exercise by the underwriters of their option to purchase             additional shares of our common stock;

 

    assumes an initial public offering price of $             per share, which is the midpoint of the price range set forth on the cover page of this prospectus;

 

    excludes 784,984 shares of our common stock issuable upon the exercise of stock options, with a weighted average exercise price of $6.27 per share, that were outstanding as of March 31, 2018; and

 

    excludes 500,000 additional shares of our common stock that are reserved for future issuance under our 2018 Omnibus Incentive Plan.


 

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SELECTED HISTORICAL CONSOLIDATED FINANCIAL DATA

The following table sets forth selected historical consolidated financial data as of and for the three months ended March 31, 2018, and as of and for the years ended December 31, 2017, 2016, 2015, 2014 and 2013. The selected balance sheet data as of March 31, 2018 and 2017, and the selected statement of income data for the three months ended March 31, 2018 and 2017, have been derived from our unaudited consolidated financial statements included elsewhere in this prospectus. The selected balance sheet data as of December 31, 2017 and 2016, and the selected statement of income data for the years ended December 31, 2017 and 2016, have been derived from our audited consolidated financial statements included elsewhere in this prospectus. The selected balance sheet data as of December 31, 2015, 2014 and 2013 and the selected statement of income data for the years ended December 31, 2015, 2014 and 2013 have been derived from our audited consolidated financial statements that are not included in this prospectus. Our historical results are not necessarily indicative of any future performance. The information presented in the following table has been adjusted to give effect to a one-for-five reverse stock split of our common shares completed effective May 4, 2018. The effect of the reverse stock split on outstanding shares and per share figures has been retroactively applied to all periods presented.

You should read the following financial data in conjunction with the other information contained in this prospectus, including in the sections entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Capitalization,” as well as our consolidated financial statements and related notes to those financial statements included elsewhere in this prospectus. The selected historical consolidated financial data presented below contains financial measures that are not presented in accordance with accounting principles generally accepted in the United States and have not been audited. See “GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures.”

 

    As of or for the Three
Months Ended

March 31,
    As of or for the Year Ended
December 31,
 
(Dollars in thousands, except per share data)   2018     2017     2017     2016     2015     2014     2013  

Statement of Income Data:

             

Total interest income

  $ 8,607     $ 7,543     $ 32,113     $ 28,460     $ 24,829     $ 22,451     $ 18,794  

Total interest expense

    829       668       2,875       2,523       2,501       2,032       1,699  

Provision for loan losses

    501       439       870       1,919       941       1,690       1,493  

Net interest income after provision for loan losses

    7,277       6,436       28,368       24,018       21,387       18,729       15,602  

Total noninterest income

    1,107       831       4,154       4,977       3,506       3,574       2,018  

Total noninterest expense

    6,067       5,376       22,433       21,538       20,406       18,829       14,447  

Provision for income taxes

    474       578       4,653       2,454       1,483       1,127       1,130  

Net income

    1,843       1,313       5,436       5,003       3,004       2,347       2,043  

Adjusted net income (1)

    1,843       1,313       6,731       5,003       3,004       2,347       2,043  

Balance Sheet Data:

             

Cash and cash equivalents

    94,569       104,606       89,751       86,975       84,674       80,167       38,625  

Investment securities

    37,338       34,806       38,336       34,994       16,150       13,757       14,439  

Loans

    678,515       596,219       656,788       596,128       499,186       431,119       359,317  

Allowance for loan losses

    8,423       7,793       8,017       7,544       5,989       5,557       4,268  

Total assets

    830,962       758,377       805,753       740,611       622,678       546,475       428,860  

Interest-bearing deposits

    473,268       436,061       460,937       424,707       370,028       333,230       256,747  

Noninterest-bearing deposits

    254,000       229,016       242,358       223,955       173,554       138,931       113,337  

Total deposits

    727,268       665,077       703,295       648,662       543,582       472,161       370,084  

Total borrowings

    33,534       28,681       33,529       28,513       20,376       19,374       18,372  

Total shareholders’ equity

    66,927       61,303       65,711       59,897       55,753       52,521       38,487  


 

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    As of or for the Three
Months Ended

March 31,
    As of or for the Year Ended
December 31,
 
(Dollars in thousands, except per share data)   2018     2017     2017     2016     2015     2014     2013  

Share and Per Share Data: (2)

             

Earnings per share—basic

  $ 0.20     $ 0.14     $ 0.59     $ 0.54     $ 0.33     $ 0.30     $ 0.29  

Earnings per share—diluted

  $ 0.20     $ 0.14     $ 0.59     $ 0.54     $ 0.33     $ 0.30     $ 0.29  

Adjusted earnings per share—diluted (3)

  $ 0.20     $ 0.14     $ 0.73     $ 0.54     $ 0.33     $ 0.30     $ 0.29  

Dividends per share

    -       -       -       -       -       -       -  

Book value per share (4)

  $ 7.23     $ 6.63     $ 7.11     $ 6.48     $ 6.04     $ 5.70     $ 5.28  

Tangible book value per share (5)

  $ 7.23     $ 6.63     $ 7.11     $ 6.48     $ 6.04     $ 5.70     $ 5.28  

Weighted average common shares outstanding–basic

    9,242,839       9,232,398       9,232,398       9,226,204       9,218,418       7,859,830       7,148,165  

Weighted average common shares outstanding–diluted

    9,248,428       9,235,475       9,237,629       9,227,216       9,220,836       7,859,830       7,148,165  

Shares outstanding at end of period

    9,253,303       9,243,546       9,248,901       9,238,788       9,232,538       9,213,204       7,289,274  

Performance Ratios:

             

Return on average assets (6)

    0.94     0.73     0.73     0.76     0.52     0.49     0.51

Adjusted return on average assets (6)(7)

    0.94     0.73     0.90     0.76     0.52     0.49     0.51

Return on average shareholders’ equity (6)

    10.96     7.78     8.27     8.56     5.52     5.33     5.56

Adjusted return on average shareholders’ equity (6)(8)

    10.96     7.78     10.24     8.56     5.52     5.33     5.56

Yield on earnings assets (6)

    4.56     4.40     4.48     4.53     4.51     4.93     4.95

Yield on loans (6)

    5.07     4.93     4.98     5.16     5.34     5.60     5.65

Cost of funds (6)

    0.46     0.41     0.42     0.42     0.48     0.47     0.47

Cost of deposits (6)

    0.37     0.31     0.32     0.36     0.46     0.44     0.43

Net interest margin (6)

    4.12     4.01     4.08     4.13     4.06     4.49     4.50

Noninterest expense to average assets (6)

    3.10     2.98     3.00     3.28     3.51     3.92     3.61

Efficiency ratio (9)

    68.28     69.76     67.18     69.67     78.99     78.48     75.59

Loans to deposits

    93.3     89.6     93.4     91.9     91.8     91.3     97.1

Credit Quality Ratios:

             

Nonperforming assets to total assets

    0.20     0.27     0.26     1.11     1.52     1.90     1.24

Nonperforming assets to total loans and OREO

    0.25     0.34     0.32     1.38     1.89     2.39     1.46

Nonperforming loans to total loans

    0.25     0.34     0.32     0.27     0.54     0.35     0.72

Allowance for loan losses to nonperforming loans

    495.76     379.22     378.16     468.28     221.32     365.35     163.90

Allowance for loan losses to total loans

    1.24     1.31     1.22     1.27     1.20     1.29     1.19

Net charge-offs to average loans (6)

    0.06     0.13     0.06     0.07     0.11     0.10     0.33

Capital Ratios:

             

Total shareholders’ equity to total assets

    8.05     8.08     8.16     8.09     8.95     9.61     8.97

Tangible equity to tangible assets (10)

    8.05     8.08     8.16     8.09     8.95     9.61     8.97

Common equity tier 1 capital ratio (11)

    11.37     11.86     11.67     11.60     11.14     N/A       N/A  

Tier 1 leverage ratio (11)

    10.09     10.07     9.94     10.11     9.58     10.10     9.58

Tier 1 risk-based capital ratio (11)

    11.37     11.86     11.67     11.60     11.14     12.46     11.56

Total risk-based capital ratio (11)

    12.60     13.11     12.90     12.85     12.31     13.71     12.78

 

(1) Adjusted net income is a non-GAAP financial measure that excludes the impact of the revaluation of our deferred tax assets as a result of the reduction in the corporate income tax rate under the Tax Cuts and Jobs Act in fiscal year 2017. The most directly comparable GAAP measure is net income. See our reconciliation of non-GAAP financial measures to their most directly comparable GAAP financial measures under the caption “GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures.”
(2) Share and per share amounts are based on total common shares outstanding, which includes common stock and nonvoting common stock.
(3) Adjusted earnings per share is a non-GAAP financial measure that excludes the impact of the revaluation of our deferred tax assets as a result of the reduction in the corporate income tax rate under the Tax Cuts and Jobs Act in fiscal year 2017. The most directly comparable GAAP measure is earnings per share. See our reconciliation of non-GAAP financial measures to their most directly comparable GAAP financial measures under the caption “GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures.”
(4) We calculate book value per share as total shareholders’ equity at the end of the relevant period divided by the outstanding number of our common shares, which includes common stock and nonvoting common stock, at the end of each period.


 

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(5) Tangible book value per share is a non-GAAP financial measure. We calculate tangible book value per share as total shareholders’ equity at the end of the relevant period, less goodwill and other intangible assets, divided by the outstanding number of our common shares, which includes common stock and nonvoting common stock, at the end of each period. The most directly comparable GAAP financial measure is book value per share. We had no goodwill or other intangible assets as of any of the dates indicated. As a result, tangible book value per share is the same as book value per share as of each of the dates indicated.
(6) Ratios for the three months ended March 31, 2018 and 2017, are annualized.
(7) Adjusted return on average assets is a non-GAAP financial measure that excludes the impact of the revaluation of our deferred tax assets as a result of the reduction in the corporate income tax rate under the Tax Cuts and Jobs Act in fiscal year 2017. The most directly comparable GAAP measure is return on average assets. See our reconciliation of non-GAAP financial measures to their most directly comparable GAAP financial measures under the caption “GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures.”
(8) Adjusted return on average shareholder’s equity is a non-GAAP financial measure that excludes the impact of the revaluation of our deferred tax assets as a result of the reduction in the corporate income tax rate under the Tax Cuts and Jobs Act in fiscal year 2017. The most directly comparable GAAP measure is return on average shareholders’ equity. See our reconciliation of non-GAAP financial measures to their most directly comparable GAAP financial measures under the caption “GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures.”
(9) Efficiency ratio represents noninterest expense divided by the sum of net interest income and noninterest income.
(10) Tangible equity to tangible assets is a non-GAAP financial measure. We calculate tangible equity to tangible assets as total shareholders’ equity at the end of the relevant period, less goodwill and other intangible assets. The most directly comparable GAAP financial measures is total shareholders’ equity to total assets. We had no goodwill or other intangible assets as of the dates indicated. As a result, tangible equity to tangible assets is the same as total shareholders’ equity to total assets as of each of the dates indicated.
(11) Capital ratios are for the Bank.


 

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GAAP RECONCILIATION AND MANAGEMENT EXPLANATION OF

NON-GAAP FINANCIAL MEASURES

Some of the financial measures included in this prospectus are not measures of financial performance recognized by GAAP. Our management uses the non-GAAP financial measures set forth below in its analysis of our performance.

 

    “Adjusted net income” is a non-GAAP measure defined as net income increased by the additional income tax expense that resulted from the revaluation of deferred tax assets as a result of the reduction in the corporate income tax rate under the recently enacted Tax Cuts and Jobs Act. The most directly comparable GAAP measure is net income.

 

    “Adjusted earnings per share” is a non-GAAP measure defined as net income, plus additional income tax expense, divided by weighted average outstanding shares (diluted). The most directly comparable GAAP measure is earnings per share.

 

    “Adjusted return on average assets” is a non-GAAP measure defined as net income, plus additional income tax expense, divided by average assets. The most directly comparable GAAP measure is return on average assets.

 

    “Adjusted return on average shareholders’ equity” is a non-GAAP measure defined as net income, plus additional income tax expense, divided by average shareholders’ equity. The most directly comparable GAAP measure is return on average shareholders’ equity.

We believe that these non-GAAP financial measures provide information that is important to investors and that is useful in understanding our results of operations. However, these non-GAAP financial measures are supplemental and are not a substitute for an analysis based on GAAP measures. As other companies may use different calculations for these measures, this presentation may not be comparable to other similarly titled measures by other companies.

 

(Dollars in thousands, except share and per share data)    As of and for the
Year Ended
December 31, 2017
 

Adjusted net income:

  

Net income

   $ 5,436  

Plus: additional income tax expense

     1,295  

Adjusted net income

   $ 6,731  

Adjusted earnings per share—diluted

  

Net income

   $ 5,436  

Plus: additional income tax expense

     1,295  

Adjusted net income

   $ 6,731  

Weighted average common shares outstanding—diluted (1)

     9,237,629  

Adjusted earnings per share—diluted (1)

   $ 0.73  

Adjusted return on average assets

  

Net income

   $ 5,436  

Plus: additional income tax expense

     1,295  

Adjusted net income

   $ 6,731  

Average assets

   $ 748,940  

Adjusted return on average assets

     0.90

Adjusted return on average shareholders’ equity

  

Net income

   $ 5,436  

Plus: additional income tax expense

     1,295  

Adjusted net income

   $ 6,731  

Average shareholders’ equity

   $ 65,720  

Adjusted return on average shareholders’ equity

     10.24

 

(1) Share and per share information has been adjusted to give effect to a one-for-five reverse stock split of our common shares completed effective May 4, 2018.


 

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RISK FACTORS

An investment in our common stock involves a number of risks. Before making a decision to purchase our common stock, you should carefully consider the following information about these risks, together with the other information contained in this prospectus. Additional risks and uncertainties not currently known to us or that we currently believe to be immaterial may also materially and adversely affect us. Many factors, including the risks described below, could result in a significant or material adverse effect on our business, financial condition, earnings and prospects. If this were to happen, the price of our common stock could decline significantly and you could lose all or part of your investment. Some statements in this prospectus, including statements in the following risk factors, constitute forward-looking statements. Please refer to “Cautionary Note Regarding Forward-Looking Statements.”

Risks Related to Our Business

Our commercial real estate lending activities expose us to increased lending risks and related loan losses.

At March 31, 2018, our commercial real estate loan portfolio totaled $453.9 million, or 66.9% of our total loan portfolio. Our current business strategy is to continue our originations of commercial real estate loans. Commercial real estate loans generally expose a lender to greater risk of non-payment and loss than one-to-four family residential mortgage loans because repayment of the loans often depends on the successful operation of the properties and the income stream of the borrowers. These loans involve larger loan balances to single borrowers or groups of related borrowers compared to one-to-four family residential mortgage loans. To the extent that borrowers have more than one commercial real estate loan outstanding, an adverse development with respect to one loan or one credit relationship could expose us to a significantly greater risk of loss compared to an adverse development with respect to a one-to-four family residential real estate loan. Moreover, if loans that are collateralized by commercial real estate become troubled and the value of the real estate has been significantly impaired, then we may not be able to recover the full contractual amount of principal and interest that we anticipated at the time we originated the loan, which could cause us to increase our provision for loan losses and would adversely affect our earnings and financial condition.

Imposition of limits by the bank regulators on commercial real estate lending activities could curtail our growth and adversely affect our earnings.

In 2006, the federal banking regulators issued joint guidance entitled “Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices,” or the CRE Guidance. Although the CRE Guidance did not establish specific lending limits, it provides that a bank’s commercial real estate lending exposure could receive increased supervisory scrutiny where total non-owner-occupied commercial real estate loans, including loans secured by apartment buildings, investor commercial real estate, and construction and land loans, represent 300% or more of an institution’s total risk-based capital, and the outstanding balance of the commercial real estate loan portfolio has increased by 50% or more during the preceding 36 months. Our total non-owner-occupied commercial real estate loans, including loans secured by apartment buildings, investor commercial real estate, and construction and land loans represented 366.8% of the Bank’s total risk-based capital at March 31, 2018. However, the increase in the portfolio over the preceding 36 months was less than 50%.

In December 2015, the federal banking regulators released a new statement on prudent risk management for commercial real estate lending, referred to herein as the 2015 Statement. In the 2015 Statement, the federal banking regulators, among other things, indicate the intent to continue “to pay special attention” to commercial real estate lending activities and concentrations going forward. If the Federal Reserve, our primary federal regulator, were to impose restrictions on the amount of commercial real estate loans we can hold in our portfolio, for reasons noted above or otherwise, our earnings would be adversely affected.

 

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Our commercial business lending activities expose us to additional lending risks.

We make commercial business loans in our market area to a variety of professionals, sole proprietorships, partnerships and corporations. As compared to commercial real estate loans, which are secured by real property, the value of which tends to be more easily ascertainable, commercial business loans are of higher risk and typically are made on the basis of the borrower’s ability to make repayment from the cash flow of the borrower’s business. As a result, the availability of funds for the repayment of commercial business loans may depend substantially on the success of the business itself. Further, any collateral securing such loans may depreciate over time, may be difficult to appraise, may fluctuate in value and may depend on the borrower’s ability to collect receivables. We have increased our focus on commercial business lending in recent years and intend to continue to focus on this type of lending in the future.

Our concentration of residential mortgage loans exposes us to increased lending risks.

At March 31, 2018, $90.6 million, or 13.4%, of our loan portfolio was secured by one-to-four family real estate, a significant majority of which is located in the Puget Sound region. One-to-four family residential mortgage lending is generally sensitive to regional and local economic conditions that significantly impact the ability of borrowers to meet their loan payment obligations, making loss levels difficult to predict. A decline in residential real estate values as a result of a downturn in the Puget Sound housing market could reduce the value of the real estate collateral securing these types of loans. Declines in real estate values could cause some of our residential mortgages to be inadequately collateralized, which would expose us to a greater risk of loss if we seek to recover on defaulted loans by selling the real estate collateral.

Our origination of construction loans exposes us to increased lending risks.

We originate commercial construction loans primarily to professional builders for the construction of one-to-four family residences, apartment buildings, and commercial real estate properties. To a lesser degree, we also originate land acquisition loans for the purpose of facilitating the ultimate construction of a home or commercial building. Our construction loans present a greater level of risk than loans secured by improved, occupied real estate due to: (1) the increased difficulty at the time the loan is made of estimating the building costs and the selling price of the property to be built; (2) the increased difficulty and costs of monitoring the loan; (3) the higher degree of sensitivity to increases in market rates of interest; and (4) the increased difficulty of working out loan problems. In addition, construction costs may exceed original estimates as a result of increased materials, labor or other costs. Construction loans also often involve the disbursement of funds with repayment dependent, in part, on the success of the project and the ability of the borrower to sell or lease the property or refinance the indebtedness.

The small to medium-sized businesses that we lend to may have fewer resources to endure adverse business developments than larger firms, which may impair our borrowers’ ability to repay loans.

We focus our business development and marketing strategy primarily on small to medium-sized businesses. Small to medium-sized businesses frequently have smaller market shares than larger firms, may be more vulnerable to economic downturns, often need substantial additional capital to expand or compete and may experience substantial volatility in operating results, any of which may impair a borrower’s ability to repay a loan. In addition, the success of a small and medium-sized business often depends on the management skills, talents and efforts of a small group of people, and the death, disability or resignation of one or more of these people could have an adverse effect on the business and its ability to repay its loan. If our borrowers are unable to repay their loans, our business, financial condition and earnings could be adversely affected.

We may not be able to adequately measure and limit our credit risk, which could lead to unexpected losses.

The business of lending is inherently risky, including risks that the principal of or interest on any loan will not be repaid timely or at all or that the value of any collateral supporting the loan will be insufficient to cover our

 

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outstanding exposure. These risks may be affected by the strength of the borrower’s business sector and local, regional and national market and economic conditions. Many of our loans are made to small to medium-sized businesses that may be less able to withstand competitive, economic and financial pressures than larger borrowers. Our risk management practices, such as monitoring the concentration of our loans within specific industries and our credit approval practices, may not adequately reduce credit risk, and our credit administration personnel, policies and procedures may not adequately adapt to changes in economic or any other conditions affecting customers and the quality of the loan portfolio. A failure to effectively measure and limit the credit risk associated with our loan portfolio could lead to unexpected losses and have a material adverse effect on our business, financial condition and results of operations.

If our allowance for loan losses is insufficient to absorb actual loan losses, our results of operations would be negatively affected.

In determining the amount of the allowance for loan losses, we analyze our loss and delinquency experience by loan categories and we consider the effect of existing economic conditions. In addition, we make various assumptions and judgments about the collectability of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans. If the actual results are different from our estimates, or our analyses are incorrect, our allowance for loan losses may not be sufficient to cover losses inherent in our loan portfolio, which would require additions to our allowance and would decrease our net income. Our emphasis on loan growth and on increasing our portfolio, as well as any future credit deterioration, will require us to increase our allowance further in the future.

In addition, our banking regulators periodically review our allowance for loan losses and could require us to increase our provision for loan losses. Any increase in our allowance for loan losses or loan charge-offs as required by regulatory authorities may have a material adverse effect on our results of operations and financial condition.

Nonperforming assets take significant time and resources to resolve and adversely affect our earnings and financial condition.

Nonperforming assets adversely affect our net income in various ways. We generally do not record interest income on other real estate owned, or OREO, or on nonperforming loans, thereby adversely affecting our income and increasing loan administration costs. When we take collateral in foreclosures and similar proceedings, we are required to mark the related asset to the then fair market value of the collateral, which may ultimately result in a loss. An increase in our level of nonperforming assets increases our risk profile and may impact the capital levels regulators believe are appropriate in light of the ensuing risk profile. While we seek to reduce problem assets through loan workouts, restructurings and otherwise, decreases in the value of the underlying collateral, or in these borrowers’ performance or financial condition, whether or not due to economic and market conditions beyond our control, could have a material effect on our business, financial condition and results of operations. In addition, the resolution of nonperforming assets requires significant commitments of time from management, which may materially and adversely impact their ability to perform their other responsibilities. We may not experience future increases in the value of nonperforming assets.

Our Small Business Administration, or SBA, lending program is dependent upon the U.S. federal government, and we face specific risks associated with originating SBA loans.

Our SBA lending program is dependent upon the U.S. federal government. As an approved participant in the SBA Preferred Lender’s Program, referred to herein as an SBA Preferred Lender, we enable our clients to obtain SBA loans without being subject to the potentially lengthy SBA approval process necessary for lenders that are not SBA Preferred Lenders. The SBA periodically reviews the lending operations of participating lenders to assess, among other things, whether the lender exhibits prudent risk management. When weaknesses are identified, the SBA may request corrective actions or impose enforcement actions, including revocation of the

 

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lender’s SBA Preferred Lender status. If we lose our status as an SBA Preferred Lender, we may lose some or all of our customers to lenders who are SBA Preferred Lenders, and as a result we could experience a material adverse effect to our financial results. Any changes to the SBA program, including but not limited to changes to the level of guarantee provided by the federal government on SBA loans, changes to program specific rules impacting volume eligibility under the guaranty program, as well as changes to the program amounts authorized by Congress or exhaustion of the available funding for SBA programs may also have a material adverse effect on our business. In addition, any default by the U.S. government on its obligations or any prolonged government shutdown could, among other things, impede our ability to originate SBA loans or sell such loans in the secondary market, which could materially and adversely affect our business, financial condition and earnings.

The SBA’s 7(a) Loan Program is the SBA’s primary program for helping start-up and existing small businesses, with financing guaranteed for a variety of general business purposes. Generally, we sell the guaranteed portion of our SBA 7(a) loans in the secondary market. These sales result in premium income for us at the time of sale and create a stream of future servicing income, as we retain the servicing rights to these loans. For the reasons described above, we may not be able to continue originating these loans or sell them in the secondary market. Furthermore, even if we are able to continue to originate and sell SBA 7(a) loans in the secondary market, we might not continue to realize premiums upon the sale of the guaranteed portion of these loans or the premiums may decline due to economic and competitive factors. When we originate SBA loans, we incur credit risk on the non-guaranteed portion of the loans, and if a customer defaults on a loan, we share any loss and recovery related to the loan pro-rata with the SBA. If the SBA establishes that a loss on an SBA guaranteed loan is attributable to significant technical deficiencies in the manner in which the loan was originated, funded or serviced by us, the SBA may seek recovery of the principal loss related to the deficiency from us. Generally, we do not maintain reserves or loss allowances for such potential claims and any such claims could materially and adversely affect our business, financial condition and earnings.

The laws, regulations and standard operating procedures that are applicable to SBA loan products may change in the future. We cannot predict the effects of these changes on our business and profitability. Because government regulation greatly affects the business and financial results of all commercial banks and bank holding companies and especially our organization, changes in the laws, regulations and procedures applicable to SBA loans could adversely affect our ability to operate profitably.

The geographic concentration of our loan portfolio and lending activities makes us vulnerable to a downturn in the economy of the Puget Sound region.

While there is not a single employer or industry in our market area on which a significant number of our customers are dependent, a substantial portion of our loan portfolio is comprised of loans secured by property located in the Puget Sound region. This makes us vulnerable to a downturn in the local economy and real estate markets. Adverse conditions in the local economy such as unemployment, recession, a catastrophic event or other factors beyond our control could impact the ability of our borrowers to repay their loans, which could impact our net interest income. Uncertainties have arisen regarding the potential for a reversal or renegotiation of international trade agreements under the current administration, and the impact such actions and other policies of the current administration may have on economic and market conditions. In addition, concerns about the performance of international economies, especially in Europe and emerging markets, and economic conditions in Asia, particularly the economies of China, South Korea and Japan, can impact the economy and financial markets here in the United States. If the national, regional and local economies experience worsening economic conditions, including high levels of unemployment, our growth and profitability could be constrained. Weak economic conditions are characterized by, among other indicators, deflation, elevated levels of unemployment, fluctuations in debt and equity capital markets, increased delinquencies on mortgage, commercial and consumer loans, residential and commercial real estate price declines, and lower home sales and commercial activity. All of these factors are generally detrimental to our business. Our business is significantly affected by monetary and other regulatory policies of the U.S. federal government, its agencies and government-sponsored entities. Changes in any of these policies are influenced by macroeconomic conditions and other factors that are beyond

 

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our control, are difficult to predict and could have a material adverse effect on our business, financial position, results of operations and growth prospects. In addition, decreases in local real estate values caused by economic conditions, recent changes in tax laws or other events could adversely affect the value of the property used as collateral for our loans, which could cause us to realize a loss in the event of a foreclosure. Further, deterioration in local economic conditions could drive the level of loan losses beyond the level we have provided for in our allowance for loan losses, which in turn could necessitate an increase in our provision for loan losses and a resulting reduction to our earnings and capital.

Economic conditions could result in increases in our level of nonperforming loans and/or reduce demand for our products and services, which could have an adverse effect on our results of operations.

Prolonged deteriorating economic conditions could significantly affect the markets in which we do business, the value of our loans and investment securities, and our ongoing operations, costs and profitability. Further, declines in real estate values and sales volumes and elevated unemployment levels may result in higher loan delinquencies, increases in our nonperforming and classified assets and a decline in demand for our products and services. These events may cause us to incur losses and may adversely affect our financial condition and earnings. Reduction in problem assets can be slow, and the process can be exacerbated by the condition of the properties securing nonperforming loans and the lengthy foreclosure process in Washington. To the extent that we must work through the resolution of assets, economic problems may cause us to incur losses and adversely affect our capital, liquidity, and financial condition.

Appraisals and other valuation techniques we use in evaluating and monitoring loans secured by real property, other real estate owned and repossessed personal property may not accurately describe the net value of the asset.

In considering whether to make a loan secured by real property, we generally require an appraisal of the property. However, an appraisal is only an estimate of the value of the property at the time the appraisal is made, and, as real estate values may change significantly in relatively short periods of time (especially in periods of heightened economic uncertainty), this estimate may not accurately describe the net value of the real property collateral after the loan is made. As a result, we may not be able to realize the full amount of any remaining indebtedness when we foreclose on and sell the relevant property. In addition, we rely on appraisals and other valuation techniques to establish the value of our OREO, and personal property that we acquire through foreclosure proceedings and to determine certain loan impairments. If any of these valuations are inaccurate, our financial statements may not reflect the correct value of our OREO, and our allowance for loan losses may not reflect accurate loan impairments. This could have a material adverse effect on our business, financial condition or results of operations. As of March 31, 2018, we did not hold any OREO or repossessed property and equipment.

Ineffective liquidity management could adversely affect our financial condition and earnings.

Effective liquidity management is essential for the operation of our business. We require sufficient liquidity to meet customer loan requests, customer deposit maturities/withdrawals, payments on our debt obligations as they come due and other cash commitments under both normal operating conditions and other unpredictable circumstances causing industry or general financial market stress. Our access to funding sources in amounts adequate to finance our activities on terms that are acceptable to us could be impaired by factors that affect us specifically or the financial services industry or economy generally. Factors that could detrimentally impact our access to liquidity sources include a downturn in the geographic markets in which our loans and operations are concentrated or difficult credit markets. Our access to deposits may also be affected by the liquidity needs of our depositors. In particular, a majority of our liabilities are checking accounts and other liquid deposits, which are payable on demand or upon several days’ notice, while by comparison, a substantial majority of our assets are loans, which cannot be called or sold in the same time frame. Although we have historically been able to replace maturing deposits and advances as necessary, we might not be able to replace such funds in the future, especially

 

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if a large number of our depositors seek to withdraw their accounts, regardless of the reason. A failure to maintain adequate liquidity could materially and adversely affect our business, financial condition and earnings.

Our agreement with Aspiration may produce limited revenue and may expose us to liability for compliance violations by Aspiration.

We have entered into an agreement with Aspiration, an online investment platform that offers socially-conscious and sustainable banking and investing, pursuant to which we will provide certain banking services for Aspiration’s new cash management account program that Aspiration intends to launch in the third quarter of 2018, including serving as the issuing bank for debit cards issued to Aspiration’s customers and establishing one or more settlement accounts for the purpose of settling customer transactions in the cash management account program. There can be no assurance that Aspiration will launch its new cash management account program on its planned schedule or achieve customer acceptance. Furthermore, although the agreement with Aspiration has an initial term (subject to two automatic renewals for successive 12-month terms) of three years from the later of July 1, 2018 or the date on which Aspiration begins enrolling customers, it may be earlier terminated by the parties under certain circumstances. If Aspiration is not successful in launching or achieving customer acceptance of its cash management account program or terminates the agreement before the end of its term, our revenue under the agreement may be limited or may cease altogether. In addition, because we will provide banking services with respect to the cash features of Aspiration’s cash management account program, our bank regulators may hold us responsible for Aspiration’s activities with respect to the marketing or administration of Aspiration’s cash management account program, which may result in increased compliance costs for us or potentially compliance violations as a result of Aspiration’s activities.

Our business strategy includes growth, and our financial condition and results of operations could be negatively affected if we fail to grow or fail to manage our growth effectively. Growing our operations could also cause our expenses to increase faster than our revenues.

Our business strategy includes growth in assets, deposits and the scale of our operations. Achieving such growth will require us to attract customers that currently bank at other financial institutions in our market area. Our ability to successfully grow will depend on a variety of factors, including our ability to attract and retain experienced bankers, the continued availability of desirable business opportunities, competition from other financial institutions in our market area and our ability to manage our growth. Growth opportunities may not be available or we may not be able to manage our growth successfully. If we do not manage our growth effectively, our financial condition and operating results could be negatively affected. Furthermore, there can be considerable costs involved in expanding deposit and lending capacity that generally require a period of time to generate the necessary revenues to offset their costs, especially in areas in which we do not have an established presence and that require alternative delivery methods. Accordingly, any such business expansion can be expected to negatively impact our earnings for some period of time until certain economies of scale are reached. Our expenses could be further increased if we encounter delays in modernizing existing facilities, opening new branches or deploying new services.

We may not be able to implement our expansion strategy, which may adversely affect our ability to maintain our historical earnings trends.

Our expansion strategy focuses on organic growth, supplemented by strategic acquisitions and expansion of the Bank’s banking location network, or de novo branching. We may not be able to execute on aspects of our expansion strategy, which may impair our ability to sustain our historical rate of growth or prevent us from growing at all. More specifically, we may not be able to generate sufficient new loans and deposits within acceptable risk and expense tolerances, obtain the personnel or funding necessary for additional growth or find suitable acquisition candidates. Various factors, such as economic conditions and competition with other financial institutions, may impede or prohibit the growth of our operations, the opening of new banking locations and the consummation of acquisitions. Further, we may be unable to attract and retain experienced bankers,

 

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which could adversely affect our growth. The success of our strategy also depends on our ability to effectively manage growth, which is dependent upon a number of factors, including our ability to adapt our credit, operational, technology and governance infrastructure to accommodate expanded operations. If we fail to implement one or more aspects of our strategy, we may be unable to maintain our historical earnings trends, which could have a material adverse effect on our business, financial condition and results of operations.

We are subject to certain risks in connection with growing through mergers and acquisitions.

It is possible that we could acquire other banking institutions, other financial services companies or branches of banks in the future. Acquisitions typically involve the payment of a premium over book and trading values and, therefore, may result in the dilution of our tangible book value per share and/or our earnings per share. Our ability to engage in future mergers and acquisitions depends on various factors, including: (1) our ability to identify suitable merger partners and acquisition opportunities; (2) our ability to finance and complete transactions on acceptable terms and at acceptable prices; and (3) our ability to receive the necessary regulatory and, when required, shareholder approvals. Our inability to engage in an acquisition or merger for any of these reasons could have an adverse impact on the implementation of our business strategies. Furthermore, mergers and acquisitions involve a number of risks and challenges, including our ability to achieve planned synergies and to integrate the branches and operations we acquire, and the internal controls and regulatory functions into our current operations, as well as the diversion of management’s attention from existing operations, which may adversely affect our ability to successfully conduct our business and negatively impact our financial results.

We rely heavily on our executive management team and other key employees, and we could be adversely affected by the unexpected loss of their services.

Our success depends in large part on the performance of our executive management team and other key personnel, as well as on our ability to attract, motivate and retain highly qualified senior and middle management and other skilled employees. Competition for qualified employees is intense, and the process of locating key personnel with the combination of skills, attributes and business relationships required to execute our business plan may be lengthy. We may not be successful in retaining our key employees, and the unexpected loss of services of one or more of our key personnel could have an adverse effect on our business because of their skills, knowledge of and business relationships within our primary markets, years of industry experience and the difficulty of promptly finding qualified replacement personnel. If the services of any of our key personnel should become unavailable for any reason, we may not be able to identify and hire qualified persons on terms acceptable to us, or at all, which could have a material adverse effect on our business, financial condition, results of operations and future prospects.

We may need to raise additional capital in the future, and such capital may not be available when needed or at all.

We may need to raise additional capital, in the form of additional debt or equity, in the future to have sufficient capital resources and liquidity to meet our commitments and fund our business needs and future growth, particularly if the quality of our assets or earnings were to deteriorate significantly. Our ability to raise additional capital, if needed, will depend on, among other things, conditions in the capital markets at that time, which are outside of our control, and our financial condition. Economic conditions and a loss of confidence in financial institutions may increase our cost of funding and limit access to certain customary sources of capital or make such capital only available on unfavorable terms, including interbank borrowings, repurchase agreements and borrowings from the discount window of the Federal Reserve. We may not be able to obtain capital on acceptable terms or at all. Any occurrence that may limit our access to the capital markets, such as a decline in the confidence of debt purchasers, depositors of our bank or counterparties participating in the capital markets or other disruption in capital markets, may adversely affect our capital costs and our ability to raise capital and, in turn, our liquidity. Further, if we need to raise capital in the future, we may have to do so when many other financial institutions are also seeking to raise capital and would then have to compete with those institutions for

 

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investors. An inability to raise additional capital on acceptable terms when needed could have a material adverse effect on our business, financial condition and results of operations.

We are subject to interest rate risk and fluctuations in interest rates may adversely affect our earnings.

The majority of our banking assets and liabilities are monetary in nature and subject to risk from changes in interest rates. Like most financial institutions, our earnings are significantly dependent on our net interest income, the principal component of our earnings, which is the difference between interest earned by us from our interest-earning assets, such as loans and investment securities, and interest paid by us on our interest-bearing liabilities, such as deposits and borrowings. We expect that we will periodically experience “gaps” in the interest rate sensitivities of our assets and liabilities, meaning that either our interest-bearing liabilities will be more sensitive to changes in market interest rates than our interest-earning assets, or vice versa. In either event, if market interest rates should move contrary to our position, this “gap” will negatively impact our earnings. The impact on earnings is more adverse when the slope of the yield curve flattens, that is, when short-term interest rates increase more than long-term interest rates or when long-term interest rates decrease more than short-term interest rates. Many factors impact interest rates, including governmental monetary policies, inflation, recession, changes in unemployment, the money supply and international economic weakness and disorder and instability in domestic and foreign financial markets. Our interest rate sensitivity profile was asset sensitive as of March 31, 2018, meaning that we estimate our net interest income would increase more from rising interest rates than from falling interest rates.

Interest rate increases often result in larger payment requirements for our borrowers, which increases the potential for default and could result in a decrease in the demand for loans. At the same time, the marketability of the property securing a loan may be adversely affected by any reduced demand resulting from higher interest rates. In a declining interest rate environment, there may be an increase in prepayments on loans as borrowers refinance their loans at lower rates. In addition, in a low interest rate environment, loan customers often pursue long-term fixed rate credits, which could adversely affect our earnings and net interest margin if rates increase. Changes in interest rates also can affect the value of loans, securities and other assets. An increase in interest rates that adversely affects the ability of borrowers to pay the principal or interest on loans may lead to an increase in nonperforming assets and a reduction of income recognized, which could have a material adverse effect on our results of operations and cash flows. Further, when we place a loan on nonaccrual status, we reverse any accrued but unpaid interest receivable, which decreases interest income. At the same time, we continue to have a cost to fund the loan, which is reflected as interest expense, without any interest income to offset the associated funding expense. Thus, an increase in the amount of nonperforming assets would have an adverse impact on net interest income. If short-term interest rates continue to remain at their historically low levels for a prolonged period, and assuming longer-term interest rates fall further, we could experience net interest margin compression as our interest-earning assets would continue to reprice downward while our interest-bearing liability rates could fail to decline in tandem. Such an occurrence would have an adverse effect on our net interest income and could have a material adverse effect on our business, financial condition and results of operations.

We may be adversely affected by recent changes in U.S. tax laws and regulations.

Changes in tax laws contained in the Tax Cuts and Jobs Act, which was enacted in December 2017, include a number of provisions that will have an impact on the banking industry, borrowers and the market for residential real estate. Included in this legislation was a reduction of the corporate income tax rate from 35% to 21%. In addition, other changes included: (i) a lower limit on the deductibility of mortgage interest on single-family residential mortgage loans, (ii) the elimination of interest deductions for home equity loans, (iii) a limitation on the deductibility of business interest expense and (iv) a limitation on the deductibility of property taxes and state and local income taxes.

The recent changes in the tax laws may have an adverse effect on the market for, and valuation of, residential properties, and on the demand for such loans in the future, and could make it harder for borrowers to make their

 

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loan payments. In addition, these recent changes may also have a disproportionate effect on taxpayers in states with high residential home prices and high state and local taxes. If home ownership becomes less attractive, demand for mortgage loans could decrease. The value of the properties securing loans in our loan portfolio may be adversely impacted as a result of the changing economics of home ownership, which could require an increase in our provision for loan losses, which would reduce our profitability and could materially adversely affect our business, financial condition and earnings.

We are dependent on our information technology and telecommunications systems and third-party service providers; systems failures, interruptions and cybersecurity breaches could have a material adverse effect on us.

Our business is dependent on the successful and uninterrupted functioning of our information technology and telecommunications systems and third-party service providers. The failure of these systems, or the termination of a third-party software license or service agreement on which any of these systems is based, could interrupt our operations. Because our information technology and telecommunications systems interface with and depend on third-party systems, we could experience service denials if demand for such services exceeds capacity or such third-party systems fail or experience interruptions. If significant, sustained or repeated, a system failure or service denial could compromise our ability to operate effectively, damage our reputation, result in a loss of customer business, and/or subject us to additional regulatory scrutiny and possible financial liability, any of which could have a material adverse effect on us.

Our third-party service providers may be vulnerable to unauthorized access, computer viruses, phishing schemes and other security breaches. We likely will expend additional resources to protect against the threat of such security breaches and computer viruses, or to alleviate problems caused by such security breaches or viruses. To the extent that the activities of our third-party service providers or the activities of our customers involve the storage and transmission of confidential information, security breaches and viruses could expose us to claims, regulatory scrutiny, litigation costs and other possible liabilities.

Security breaches and cybersecurity threats could compromise our information and expose us to liability, which would cause our business and reputation to suffer.

In the ordinary course of our business, we collect and store sensitive data, including our proprietary business information and that of our customers, suppliers and business partners, as well as personally identifiable information about our customers and employees. The secure processing, maintenance and transmission of this information is critical to our operations and business strategy. We, our customers, and other financial institutions with which we interact, are subject to ongoing, continuous attempts to penetrate key systems by individual hackers, organized criminals, and in some cases, state-sponsored organizations. While we have established policies and procedures to prevent or limit the impact of cyber-attacks, there can be no assurance that such events will not occur or will be adequately addressed if they do. In addition, we also outsource certain cybersecurity functions, such as penetration testing, to third-party service providers, and the failure of these service providers to adequately perform such functions could increase our exposure to security breaches and cybersecurity threats. Despite our security measures, our information technology and infrastructure may be vulnerable to attacks by hackers or breached due to employee error, malfeasance or other malicious code and cyber-attacks that could have an impact on information security. Any such breach or attacks could compromise our networks and the information stored there could be accessed, publicly disclosed, lost or stolen. Any such unauthorized access, disclosure or other loss of information could result in legal claims or proceedings, liability under laws that protect the privacy of personal information, and regulatory penalties; disrupt our operations and the services we provide to customers; damage our reputation; and cause a loss of confidence in our products and services, all of which could adversely affect our business, financial condition and earnings.

 

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We must keep pace with technological change to remain competitive.

Financial products and services have become increasingly technology-driven. Our ability to meet the needs of our customers competitively, and in a cost-efficient manner, is dependent on the ability to keep pace with technological advances and to invest in new technology as it becomes available, as well as related essential personnel. In addition, technology has lowered barriers to entry into the financial services market and made it possible for financial technology companies and other non-bank entities to offer financial products and services traditionally provided by banks. The ability to keep pace with technological change is important, and the failure to do so, due to cost, proficiency or otherwise, could have a material adverse impact on our business and therefore on our financial condition and results of operations.

Because the nature of the financial services business involves a high volume of transactions, we face significant operational risks.

We rely on the ability of our employees and systems to process a high number of transactions. Operational risk is the risk of loss resulting from our operations, including but not limited to, the risk of fraud by employees or outside persons, the execution of unauthorized transactions by employees, errors relating to transaction processing and technology, breaches of our internal control system and compliance requirements, and business continuation and disaster recovery. Insurance coverage may not be available for such losses, or where available, such losses may exceed insurance limits. This risk of loss also includes the potential legal actions that could arise as a result of an operational deficiency or as a result of noncompliance with applicable regulations, adverse business decisions or their implementation, and customer attrition due to potential negative publicity. Although our control testing has not identified any significant deficiencies in our internal control system, a breakdown in our internal control system, improper operation of our systems or improper employee actions could result in material financial loss to us, the imposition of regulatory action, and damage to our reputation.

We are subject to laws regarding the privacy, information security and protection of personal information and any violation of these laws or another incident involving personal, confidential or proprietary information of individuals could damage our reputation and otherwise adversely affect our business, financial condition and earnings.

Our business requires the collection and retention of large volumes of customer data, including personally identifiable information in various information systems that we maintain and in those maintained by third parties with whom we contract to provide data services. We also maintain important internal company data such as personally identifiable information about our employees and information relating to our operations. We are subject to complex and evolving laws and regulations governing the privacy and protection of personal information of individuals (including customers, employees, suppliers and other third parties). For example, our business is subject to the Gramm-Leach-Bliley Act which, among other things: (i) imposes certain limitations on our ability to share nonpublic personal information about our customers with nonaffiliated third parties; (ii) requires that we provide certain disclosures to customers about our information collection, sharing and security practices and afford customers the right to “opt out” of any information sharing by us with nonaffiliated third parties (with certain exceptions); and (iii) requires that we develop, implement and maintain a written comprehensive information security program containing appropriate safeguards based on our size and complexity, the nature and scope of our activities, and the sensitivity of customer information we process, as well as plans for responding to data security breaches. Various state and federal laws and regulations impose data security breach notification requirements with varying levels of individual, consumer, regulatory or law enforcement notification in certain circumstances in the event of a security breach. Ensuring that our collection, use, transfer and storage of personal information complies with all applicable laws and regulations can increase our costs.

Furthermore, we may not be able to ensure that all of our clients, suppliers, counterparties and other third parties have appropriate controls in place to protect the confidentiality of the information that they exchange with

 

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us, particularly where such information is transmitted by electronic means. If personal, confidential or proprietary information of customers or others were to be mishandled or misused (in situations where, for example, such information was erroneously provided to parties who are not permitted to have the information, or where such information was intercepted or otherwise compromised by third parties), we could be exposed to litigation or regulatory sanctions under personal information laws and regulations. Concerns regarding the effectiveness of our measures to safeguard personal information, or even the perception that such measures are inadequate, could cause us to lose customers or potential customers for our products and services and thereby reduce our revenues. Accordingly, any failure or perceived failure to comply with applicable privacy or data protection laws and regulations may subject us to inquiries, examinations and investigations that could result in requirements to modify or cease certain operations or practices or in significant liabilities, fines or penalties, and could damage our reputation and otherwise adversely affect our business, financial condition and earnings.

We are dependent on the use of data and modeling in our management’s decision-making, and faulty data or modeling approaches could negatively impact our decision-making ability or possibly subject us to regulatory scrutiny in the future.

The use of statistical and quantitative models and other quantitative analyses is widespread in bank decision-making, and the employment of such analyses is becoming increasingly widespread in our operations. Liquidity stress testing, interest rate sensitivity analysis, and the identification of possible violations of anti-money laundering regulations are all examples of areas in which we are dependent on models and the data that underlies them. The use of statistical and quantitative models is also becoming more prevalent in regulatory compliance. While we are not currently subject to annual stress testing under the Dodd-Frank Wall Street Reform and Consumer Protection Act, or the Dodd-Frank Act, we anticipate that model-derived testing may become more extensively implemented by regulators in the future.

We anticipate data-based modeling will penetrate further into bank decision-making, particularly risk management efforts, as the capacities developed to meet rigorous stress testing requirements are able to be employed more widely and in differing applications. While we believe these quantitative techniques and approaches improve our decision-making, they also create the possibility that faulty data or flawed quantitative approaches could negatively impact our decision-making ability or, if we become subject to regulatory stress testing in the future, adverse regulatory scrutiny. Further, because of the complexity inherent in these approaches, misunderstanding or misuse of their outputs could similarly result in suboptimal decision-making.

We depend on the accuracy and completeness of information provided to us by our borrowers and counterparties and any misrepresented information could adversely affect our business, financial condition and earnings.

In deciding whether to approve loans or to enter into other transactions with borrowers and counterparties, we rely on information furnished to us by, or on behalf of, borrowers and counterparties, including financial statements, credit reports and other financial information. We also rely on representations of borrowers and counterparties as to the accuracy and completeness of that information and, with respect to financial statements, on reports of independent auditors. If any of this information is intentionally or negligently misrepresented and such misrepresentation is not detected prior to loan funding, the value of the loan may be significantly lower than expected and we may be subject to regulatory action. Whether a misrepresentation is made by the loan applicant, another third party, or one of our employees, we generally bear the risk of loss associated with the misrepresentation. Our controls and processes may not have detected, or may not detect all, misrepresented information in our loan originations or from our business clients. Any such misrepresented information could adversely affect our business, financial condition and earnings.

We are subject to certain operational risks, including, but not limited to, customer, employee or third-party fraud and data processing system failures and errors.

Because we are a financial institution, employee errors and employee or customer misconduct could subject us in particular to financial losses or regulatory sanctions and seriously harm our reputation. Misconduct by our

 

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employees could include hiding unauthorized activities from us, improper or unauthorized activities on behalf of our customers or improper use of confidential information, each of which can be particularly damaging for financial institutions. It is not always possible to prevent employee errors and misconduct, and the precautions we take to prevent and detect this activity may not be effective in all cases. Employee errors could also subject us to financial claims for negligence.

We maintain a system of internal controls to mitigate operational risks, including data processing system failures and errors and customer or employee fraud, as well as insurance coverage designed to protect us from material losses associated with these risks, including losses resulting from any associated business interruption. If our internal controls fail to prevent or detect an occurrence, or if any resulting loss is not insured or exceeds applicable insurance limits, it could adversely affect our business, financial condition and earnings.

The building of market share through our branch office strategy, and our ability to achieve profitability on new branch offices, may increase our expenses and negatively affect our earnings.

We believe there are branch expansion opportunities within our market area and adjacent markets and will seek to grow our deposit base by adding branches to our existing network. There are considerable costs involved in opening branch offices, especially in light of the capabilities needed to compete in today’s environment. Moreover, new branch offices generally require a period of time to generate sufficient revenues to offset their costs, especially in areas in which we do not have an established presence. Accordingly, new branch offices could negatively impact our earnings and may do so for some period of time. Our investments in products and services, and the related personnel required to implement new policies and procedures, take time to earn returns and can be expected to negatively impact our earnings for the foreseeable future. The profitability of our expansion strategy will depend on whether the income that we generate from the new branch offices will offset the increased expenses resulting from operating these branch offices.

Strong competition within our market area could hurt our profits and slow growth.

Our profitability depends upon our continued ability to compete successfully in our market area. We face intense competition both in making loans and attracting deposits. Our competitors for commercial real estate loans include other community banks and commercial lenders, some of which are larger than us and have greater resources and lending limits than we have and offer services that we do not provide. We face stiff competition for one-to-four family residential loans from other financial service providers, including large national residential lenders and local community banks. Other competitors for one-to-four family residential loans include credit unions and mortgage brokers which keep overhead costs and mortgage rates down by selling loans and not holding or servicing them. Price competition for loans and deposits might result in us earning less on our loans and paying more on our deposits, which reduces net interest income. We expect competition to remain strong in the future.

The Washington State Department of Financial Institutions, or Washington DFI, recently entered into a multi-state agreement with six other states that is intended to streamline the licensing process for money service businesses, which include money transmitters and payment service providers. Increasing the relative ease of obtaining a license to operate a money service business within the state of Washington may encourage financial technology, or fintech, companies to offer services in the state, thereby increasing competition for such services.

Negative public opinion regarding our company or failure to maintain our reputation in the communities we serve could adversely affect our business and prevent us from growing our business.

As a community bank, our reputation within the communities we serve is critical to our success. We believe we have set ourselves apart from our competitors by building strong personal and professional relationships with our customers and being active members of the communities we serve. As such, we strive to enhance our reputation by recruiting, hiring and retaining employees who share our core values of being an integral part of the

 

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communities we serve and delivering superior service to our customers. If our reputation is negatively affected by the actions of our employees or otherwise, we may be less successful in attracting new talent and customers or may lose existing customers, and our business, financial condition and earnings could be adversely affected. Further, negative public opinion can expose us to litigation and regulatory action and delay and impede our efforts to implement our expansion strategy, which could further adversely affect our business, financial condition and earnings.

We could recognize losses on investment securities held in our securities portfolio, particularly if interest rates increase or economic and market conditions deteriorate.

While we attempt to invest a significant majority of our total assets in loans (our loan-to-asset ratio was 81.7% as of March 31, 2018), we invest a percentage of our total assets (4.5% as of March 31, 2018) in investment securities with the primary objectives of providing a source of liquidity and meeting pledging requirements. As of March 31, 2018, the fair value of our available for sale investment securities portfolio was $36.0 million, which included a net unrealized loss of $2.3 million. Factors beyond our control can significantly and adversely influence the fair value of securities in our portfolio. For example, fixed-rate securities are generally subject to decreases in market value when interest rates rise. Additional factors include, but are not limited to, rating agency downgrades of the securities, defaults by the issuer or individual borrowers with respect to the underlying securities, and instability in the credit markets. Any of the foregoing factors could cause other-than-temporary impairment in future periods and result in realized losses. The process for determining whether impairment is other-than-temporary usually requires difficult, subjective judgments about the future financial performance of the issuer and any collateral underlying the security in order to assess the probability of receiving all contractual principal and interest payments on the security. Although we have not recognized other-than-temporary impairment related to our investment portfolio as of March 31, 2018, changing economic and market conditions affecting interest rates, the financial condition of issuers of the securities and the performance of the underlying collateral, among other factors, may cause us to recognize losses in future periods, which could have a material adverse effect on our business, financial condition and results of operations.

The accuracy of our financial statements and related disclosures could be affected if the judgments, assumptions or estimates used in our critical accounting policies are inaccurate.

The preparation of financial statements and related disclosures in conformity with GAAP requires us to make judgments, assumptions and estimates that affect the amounts reported in our consolidated financial statements and related notes to those financial statements. Our critical accounting policies, which are included in the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this prospectus, describe those significant accounting policies and methods used in the preparation of our consolidated financial statements that we consider “critical” because they require judgments, assumptions and estimates that materially affect our consolidated financial statements and related disclosures. As a result, if future events or regulatory views concerning such analysis differ significantly from the judgments, assumptions and estimates in our critical accounting policies, those events or assumptions could have a material impact on our consolidated financial statements and related disclosures, in each case resulting in our needing to revise or restate prior period financial statements, cause damage to our reputation and the price of our common stock, and adversely affect our business, financial condition and earnings.

We expect that the implementation of a new accounting standard could require us to increase our allowance for loan losses and may have a material adverse effect on our financial condition and results of operations.

The Financial Accounting Standards Board, or FASB, has adopted a new accounting standard that will be effective for our first fiscal year after December 15, 2019. This standard, referred to as Current Expected Credit Loss, or CECL, will require financial institutions to determine periodic estimates of lifetime expected credit losses on loans, and provide for the expected credit losses as allowances for loan losses. This will change the current method of providing allowances for loan losses that are probable, which we expect could require us to

 

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increase our allowance for loan losses, and will likely greatly increase the data we would need to collect and review to determine the appropriate level of the allowance for loan losses. Any increase in our allowance for loan losses, or expenses incurred to determine the appropriate level of the allowance for loan losses, may have a material adverse effect on our financial condition and results of operations.

We may be subject to environmental liabilities in connection with the real properties we own and the foreclosure on real estate assets securing our loan portfolio.

In the course of our business, we may purchase real estate in connection with our acquisition and expansion efforts, or we may foreclose on and take title to real estate or otherwise be deemed to be in control of property that serves as collateral on loans we make. As a result, we could be subject to environmental liabilities with respect to those properties. We may be held liable to a governmental entity or to third parties for property damage, personal injury, investigation and clean-up costs incurred by these parties in connection with environmental contamination, or we may be required to investigate or clean up hazardous or toxic substances or chemical releases at a property. The costs associated with investigation or remediation activities could be substantial. In addition, if we are the owner or former owner of a contaminated site, we may be subject to common law claims by third parties based on damages and costs resulting from environmental contamination emanating from the property.

The cost of removal or abatement may substantially exceed the value of the affected properties or the loans secured by those properties, we may not have adequate remedies against the prior owners or other responsible parties and we may not be able to resell the affected properties either before or after completion of any such removal or abatement procedures. If material environmental problems are discovered before foreclosure, we generally will not foreclose on the related collateral or will transfer ownership of the loan to a subsidiary. It should be noted, however, that the transfer of the property or loans to a subsidiary may not protect us from environmental liability. Furthermore, despite these actions on our part, the value of the property as collateral will generally be substantially reduced or we may elect not to foreclose on the property and, as a result, we may suffer a loss upon collection of the loan. Any significant environmental liabilities could have a material adverse effect on our business, financial condition and results of operations.

Risks Related to Our Industry

Regulation of the financial services industry is intense, and we may be adversely affected by changes in laws and regulations.

We are subject to extensive government regulation, supervision and examination. Such regulation, supervision and examination govern the activities in which we may engage, and are intended primarily for the protection of the deposit insurance fund and the Bank’s depositors, rather than for shareholders.

In 2010 and 2011, in response to the financial crisis and recession that began in 2008, significant regulatory and legislative changes resulted in broad reform and increased regulation affecting financial institutions. The Dodd-Frank Act has created a significant shift in the way financial institutions operate. The Dodd-Frank Act also created the Consumer Financial Protection Bureau, or CFPB, to implement consumer protection and fair lending laws, a function that was formerly performed by the depository institution regulators. The Dodd-Frank Act contains various provisions designed to enhance the regulation of depository institutions and prevent the recurrence of a financial crisis such as that which occurred in 2008 and 2009. The Dodd-Frank Act has had and may continue to have a material impact on our operations, particularly through increased regulatory burden and compliance costs. On May 24, 2018, the Economic Growth, Regulatory Relief, and Consumer Protection Act, or the EGRRCPA, became law. Among other things, the EGRRCPA changes certain of the regulatory requirements of the Dodd-Frank Act and includes provisions intended to relieve the regulatory burden on community banks. We cannot currently predict the impact of this legislation on us. Any future legislative changes could have a material impact on our profitability, the value of assets held for investment or the value of collateral for loans.

 

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Future legislative changes could also require changes to business practices and potentially expose us to additional costs, liabilities, enforcement action and reputational risk.

Federal regulatory agencies have the ability to take strong supervisory actions against financial institutions that have experienced increased loan production and losses and other underwriting weaknesses or have compliance weaknesses. These actions include entering into formal or informal written agreements and cease and desist orders that place certain limitations on their operations. If we were to become subject to a regulatory action, such action could negatively impact our ability to execute our business plan, and result in operational restrictions, as well as our ability to grow, pay dividends, repurchase stock or engage in mergers and acquisitions. See “Supervision and Regulation—Bank Regulation and Supervision—Capital Adequacy” for a discussion of regulatory capital requirements.

Federal banking agencies periodically conduct examinations of our business, including compliance with laws and regulations, and our failure to comply with any supervisory actions to which we are or become subject as a result of such examinations could adversely affect us.

As part of the bank regulatory process, the Federal Reserve and the Washington DFI periodically conduct comprehensive examinations of our business, including compliance with laws and regulations. If, as a result of an examination, either of these banking agencies were to determine that the financial condition, capital resources, asset quality, earnings prospects, management, liquidity, asset sensitivity, risk management or other aspects of any of our operations had become unsatisfactory, or that our Company, the Bank or their respective management were in violation of any law or regulation, it may take a number of different remedial actions as it deems appropriate. The Federal Reserve may enjoin “unsafe or unsound” practices or violations of law, require affirmative actions to correct any conditions resulting from any violation or practice, issue an administrative order that can be judicially enforced, direct an increase in our capital levels, restrict our growth, assess civil monetary penalties against us, the Bank or their respective officers or directors, and remove officers and directors. The FDIC also has authority to review our financial condition, and, if the FDIC were to conclude that the Bank or its directors were engaged in unsafe or unsound practices, that the Bank was in an unsafe or unsound condition to continue operations, or the Bank or the directors violated applicable law, the FDIC could move to terminate the Bank’s deposit insurance. If we become subject to such regulatory actions, our business, financial condition, earnings and reputation could be adversely affected.

Many of our new activities and expansion plans require regulatory approvals, and failure to obtain these approvals may restrict our growth.

We intend to complement and expand our business by pursuing strategic acquisitions of financial institutions and other complementary businesses, and expansion of the Bank’s banking location network, or de novo branching. Generally, we must receive federal and state regulatory approval before we can acquire a depository institution or related business insured by the FDIC or before we open a de novo branch. In determining whether to approve a proposed acquisition, federal banking regulators will consider, among other factors, the effect of the acquisition on competition, our financial condition, our future prospects, and the impact of the proposal on U.S. financial stability. The regulators also review current and projected capital ratios and levels, the competence, experience and integrity of management and its record of compliance with laws and regulations, the convenience and needs of the communities to be served (including the acquiring institution’s record of compliance under the Community Reinvestment Act, or the CRA) and the effectiveness of the acquiring institution in combating money laundering activities. Such regulatory approvals may not be granted on terms that are acceptable to us, or at all.

Financial institutions, such as the Bank, face a risk of noncompliance with and enforcement action under the Bank Secrecy Act and other anti-money laundering statutes and regulations.

The Bank Secrecy Act, the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001, or the USA PATRIOT Act, and other laws and regulations require

 

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financial institutions, among other duties, to institute and maintain an effective anti-money laundering program and file suspicious activity and currency transaction reports as appropriate. The Financial Crimes Enforcement Network, established by the U.S. Department of the Treasury, or the Treasury Department, to administer the Bank Secrecy Act, has authority to impose significant civil money penalties for violations of these requirements and has recently engaged in coordinated enforcement efforts with the individual federal banking regulators, as well as the U.S. Department of Justice, Drug Enforcement Administration and the Internal Revenue Service. There is also increased scrutiny of compliance with the sanctions programs and rules administered and enforced by the Treasury Department’s Office of Foreign Assets Control.

In order to comply with regulations, guidelines and examination procedures in this area, we have dedicated significant resources to our anti-money laundering program. If our policies, procedures and systems are deemed deficient, we could be subject to liability, including fines and regulatory actions such as restrictions on our ability to pay dividends and the inability to obtain regulatory approvals to proceed with certain aspects of our business plans, including acquisitions and de novo branching.

We are subject to numerous laws designed to protect consumers, including the Community Reinvestment Act, or CRA, and fair lending laws, and failure to comply with these laws could lead to a wide variety of sanctions.

The CRA requires the Federal Reserve to assess the Bank’s performance in meeting the credit needs of the communities it serves, including low- and moderate-income neighborhoods, and if the Federal Reserve determines that the Bank needs to improve its performance or is in substantial non-compliance with CRA requirements, various adverse regulatory consequences may ensue. In addition, the Equal Credit Opportunity Act, the Fair Housing Act and other fair lending laws and regulations impose nondiscriminatory lending requirements on financial institutions. The Consumer Financial Protection Bureau, or CFPB, the U.S. Department of Justice and other federal agencies are responsible for enforcing these laws and regulations. The CFPB was created under the Dodd-Frank Act to centralize responsibility for consumer financial protection with broad rulemaking authority to administer and carry out the purposes and objectives of federal consumer financial laws with respect to all financial institutions that offer financial products and services to consumers. The CFPB is also authorized to prescribe rules applicable to any covered person or service provider, identifying and prohibiting acts or practices that are “unfair, deceptive, or abusive” in connection with any transaction with a consumer for a consumer financial product or service, or the offering of a consumer financial product or service. The ongoing broad rulemaking powers of the CFPB have potential to have a significant impact on the operations of financial institutions offering consumer financial products or services.

A successful regulatory challenge to an institution’s performance under the CRA, fair lending laws or regulations, or consumer lending laws and regulations could result in a wide variety of sanctions, including damages and civil money penalties, injunctive relief, restrictions on mergers and acquisitions activity, restrictions on expansion, and restrictions on entering new business lines. Private parties may also have the ability to challenge an institution’s performance under fair lending laws in private class action litigation. Such actions could have a material adverse effect on our business, financial condition and results of operations.

Federal, state and local consumer lending laws may restrict our ability to originate certain mortgage loans or increase our risk of liability with respect to such loans and could increase our cost of doing business.

Federal, state and local laws have been adopted that are intended to eliminate certain lending practices considered “predatory.” These laws prohibit practices such as steering borrowers away from more affordable products, selling unnecessary insurance to borrowers, repeatedly refinancing loans and making loans without a reasonable expectation that the borrowers will be able to repay the loans irrespective of the value of the underlying property. It is our policy not to make predatory loans, but these laws create the potential for liability with respect to our lending activities. They increase our cost of doing business and, ultimately, may prevent us from making certain loans and cause us to reduce the average percentage rate or the points and fees on loans that we do make.

 

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The expanding body of federal, state and local regulations and/or the licensing of loan servicing, collections or other aspects of our business and our sales of loans to third parties may increase the cost of compliance and the risks of noncompliance and subject us to litigation.

We service most of our own loans, and loan servicing is subject to extensive regulation by federal, state and local governmental authorities, as well as various laws and judicial and administrative decisions imposing requirements and restrictions on those activities. The volume of new or modified laws and regulations has increased in recent years and, in addition, some individual municipalities have begun to enact laws that restrict loan servicing activities, including delaying or temporarily preventing foreclosures or forcing the modification of certain mortgages. If regulators impose new or more restrictive requirements, we may incur additional significant costs to comply with such requirements, which may further adversely affect us. In addition, were we to be subject to regulatory investigation or regulatory action regarding our loan modification and foreclosure practices, our business, financial condition and earnings could be adversely affected.

Our failure to comply with applicable laws and regulations could possibly lead to: civil and criminal liability; loss of licensure; damage to our reputation in the industry; fines and penalties and litigation, including class action lawsuits; and administrative enforcement actions. Any of these outcomes could materially and adversely affect us.

The Federal Reserve may require us to commit capital resources to support the Bank.

The Federal Reserve requires a bank holding company to act as a source of financial and managerial strength to its subsidiary banks and to commit resources to support its subsidiary banks. Under the “source of strength” doctrine that was codified by the Dodd-Frank Act, the Federal Reserve may require a bank holding company to make capital injections into a troubled subsidiary bank at times when the bank holding company may not otherwise be inclined to do so and may charge the bank holding company with engaging in unsafe and unsound practices for failure to commit resources to such a subsidiary bank. Under the prompt corrective action regime, if the Bank were to become undercapitalized, we would be required to guarantee the Bank’s plan to restore its capital subject to certain limits. See “Supervision and Regulation—Bank Regulation and Supervision—Prompt Corrective Action.” Accordingly, we could be required to provide financial assistance to the Bank if it experiences financial distress.

A capital injection may be required at a time when our resources are limited, and we may be required to borrow the funds or raise capital to make the required capital injection. Any loan by a bank holding company to its subsidiary bank is subordinate in right of payment to deposits and certain other indebtedness of such subsidiary bank. In the event of a bank holding company’s bankruptcy, the bankruptcy trustee will assume any commitment by the holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank. Moreover, bankruptcy law provides that claims based on any such commitment will be entitled to a priority of payment over the claims of the holding company’s general unsecured creditors, including the holders of any note obligations. Thus, any borrowing by a bank holding company for the purpose of making a capital injection to a subsidiary bank often becomes more difficult and expensive relative to other corporate borrowings.

We could be adversely affected by the soundness of other financial institutions.

Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships. We have exposure to many different industries and counterparties, and routinely execute transactions with counterparties in the financial services industry, including commercial banks, brokers and dealers, investment banks and other institutional clients. Many of these transactions expose us to credit risk in the event of a default by a counterparty or client. In addition, our credit risk may be exacerbated when our collateral cannot be foreclosed upon or is liquidated at prices not sufficient to recover the full amount of the credit or derivative exposure due. Any such losses could adversely affect our business, financial condition and earnings.

 

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Risks Related to an Investment in our Common Stock and this Offering

There is currently no regular market for our common stock. An active, liquid market for our common stock may not develop or be sustained upon completion of this offering, which may impair your ability to sell your shares.

Prior to this offering, there has been no established public trading market for our common stock. We have applied to list our common stock on the Nasdaq Global Select Market, but an active trading market for our common stock may not develop or be sustained following this offering. A public trading market having the desired characteristics of depth, liquidity and orderliness depends upon the presence in the marketplace and independent decisions of willing buyers and sellers of our common stock, over which we have no control. Without an active, liquid trading market for our common stock, shareholders may not be able to sell their shares at the volume, prices and times desired. Moreover, the lack of an established market could materially and adversely affect the value of our common stock. In addition, the market price of our common stock could decline significantly below the initial public offering price. The initial public offering price per share will be determined by negotiation between us and the underwriters and may not be indicative of the market price of our common stock after completion of this offering.

The trading price of our common stock may decline after this offering.

The trading price of our common stock may decline after this offering for many reasons, some of which are beyond our control, including:

 

    actual or anticipated fluctuations in our operating results, financial condition or asset quality;

 

    changes in economic or business conditions;

 

    the effects of, and changes in, trade, monetary and fiscal policies, including the interest rate policies of the Federal Reserve;

 

    publication of research reports about us, our competitors, or the financial services industry generally, or changes in, or failure to meet, securities analysts’ estimates of our financial and operating performance, or lack of research reports by industry analysts or ceasing of coverage;

 

    operating and stock price performance of companies that investors deem comparable to us;

 

    additional or anticipated sales of our common stock or other securities by us or our existing shareholders;

 

    additions or departures of key personnel;

 

    perceptions in the marketplace regarding our competitors or us;

 

    significant acquisitions or business combinations, strategic partnerships, joint ventures or capital commitments by or involving our competitors or us;

 

    other economic, competitive, governmental, regulatory and technological factors affecting our operations, pricing, products and services; and

 

    other news, announcements or disclosures (whether by us or others) related to us, our competitors, our primary markets or the financial services industry.

In addition, the stock market in general (and financial institutions stocks in particular) has experienced significant volatility that often has been unrelated to the operating performance of particular companies. These market fluctuations could adversely affect the trading price of our common stock, regardless of our actual operating performance. As a result, the trading price of our common stock may be less than the initial public offering price, and you may not be able to sell your shares at or above the price you pay to purchase them.

 

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Future sales of our common stock may affect the trading price of our common stock and the future exercise of options may lower the price of our common stock.

Sales of a substantial number of shares of our common stock in the public market after completion of this offering, or the perception that such sales could occur, may adversely affect the trading price of our common stock and may make it more difficult for you to sell your shares at a time and price that you determine appropriate. Upon completion of this offering, there will be                shares of our common stock (or                shares if the underwriters exercise in full their option to purchase additional shares) and                shares of our nonvoting common stock outstanding. These amounts do not include the potential issuance, as of March 31, 2018, of 784,984 shares of our common stock subject to issuance upon exercise of outstanding stock options, 500,000 additional shares of our common stock that were reserved for issuance under our 2018 Omnibus Incentive Plan, or                shares of Class C Nonvoting Common Stock that are not convertible by the holder, but are convertible on a one-for-one basis into shares of our common stock under certain circumstances. See “Description of Capital Stock” and “Executive Compensation.” We, our executive officers and directors, the selling shareholders and certain other shareholders who beneficially own in the aggregate approximately                % of our currently outstanding shares of common stock have entered into 180-day lock-up agreements. The lock-up agreements are described in “Shares Eligible for Future Sale—Lock-Up Agreements.” An aggregate of                shares of our common stock and nonvoting common stock will be subject to these lock-up agreements upon completion of this offering, excluding any shares that may be purchased in this offering by our officers and directors and their respective affiliates through the directed share program described in “Underwriting (Conflicts of Interest)—Directed Share Program.

Future equity issuances could result in dilution, which could cause the price of our common stock to decline.

We are generally not restricted from issuing additional shares of our common stock or nonvoting common stock, up to the 300,000,000 common shares authorized in our second amended and restated articles of incorporation, or articles of incorporation (subject to Nasdaq shareholder approval rules). We may issue additional shares of our common stock, or securities convertible into or exchangeable for such shares, in subsequent public or private offerings or in connection with future acquisitions. If we choose to raise capital by selling shares of our common stock, the issuance could have a dilutive effect on the holders of our common stock and could have a material negative effect on the market price of our common stock.

Investors in this offering will suffer immediate and substantial dilution.

The initial public offering price per share of our common stock is expected to be significantly higher than the tangible book value per share of our common stock immediately following this offering. Accordingly, if you purchase shares in this offering, you will suffer immediate and substantial dilution of your investment. Based upon the issuance and sale of            shares of our common stock at an assumed initial public offering price of $            per share (the midpoint of the price range set forth on the cover page of this prospectus), after deducting underwriting discounts and estimated offering expenses payable by us, you will incur immediate dilution of approximately $            in tangible book value per share if you purchase common stock in this offering. See “Dilution.”

If securities or industry analysts do not publish research or publish inaccurate or unfavorable research about our business, the price and trading volume of our common stock could decline.

The trading market for our common stock will depend in part on the research and reports that securities or industry analysts publish about us or our business. We do not currently have and may never obtain research coverage by securities and industry analysts. If no securities or industry analysts commence coverage of us, the trading price for our common stock could be negatively impacted. If we obtain securities or industry analyst coverage and if one or more of the analysts who covers us downgrades our common stock or publishes inaccurate or unfavorable research about our business, the trading price of our common stock would likely decline. If one or

 

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more of these analysts ceases coverage of us or fails to publish reports on us regularly, demand for our common stock could decrease, which could cause our stock price and trading volume to decline.

We may not pay dividends on our common stock in the future.

Holders of our common stock are only entitled to receive dividends when, as and if declared by our board of directors out of funds legally available for dividends. We have not historically declared or paid dividends on our common stock and we do not intend to declare or pay dividends on our common stock in the near term. In addition, we are a bank holding company, and our ability to declare and pay dividends is dependent on federal regulatory considerations, including the guidelines of the Federal Reserve regarding capital adequacy and dividends. It is the policy of the Federal Reserve that bank holding companies should generally pay dividends on common stock only out of earnings, and only if prospective earnings retention is consistent with the organization’s expected future needs, asset quality and financial condition. In addition, if required payments on our outstanding junior subordinated debentures are not made or suspended, we may be prohibited from paying dividends on our common stock. We are also subject to certain restrictions on our right to pay dividends on our capital stock in the event we have failed to make any required payment of interest or principal under the terms of our subordinated note. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Financial Condition—Borrowings” for further information regarding restrictions under our outstanding junior subordinated debentures and our subordinated note.

Our board of directors, executive officers and principal shareholders have significant control over our business.

As of March 31, 2018, our directors, executive officers and principal shareholders beneficially owned an aggregate of 5,781,581 shares of our common stock, or approximately 65% of our issued and outstanding shares of common stock, excluding 423,373 shares subject to outstanding stock options. Following the completion of this offering, that same group will beneficially own in the aggregate approximately    % of our outstanding common stock (or    % if the underwriters exercise in full their option to purchase additional shares), excluding any shares that may be purchased in this offering by our directors and executive officers through the directed share program described in “Underwriting (Conflicts of Interest)—Directed Share Program.” Consequently, our directors, executive officers and principal shareholders will be able to significantly affect our affairs and policies, including the outcome of the election of directors and the potential outcome of other matters submitted to a vote of our shareholders, such as mergers, the sale of substantially all of our assets and other extraordinary corporate matters. This influence may also have the effect of delaying or preventing changes of control or changes in management, or limiting the ability of our other shareholders to approve transactions that they may deem to be in the best interests of our Company. The interests of these insiders could conflict with the interests of our other shareholders, including you.

In addition, pursuant to separate Investment Agreements between us and CJA Private Equity Financial Restructuring Master Fund I LP, Montlake Capital II, L.P. and Montlake Capital II-B, L.P., and Steven D. Hovde, for so long as the investor owns in aggregate 4.9% or more of our outstanding common stock, we are obligated to appoint one representative of the investor to the boards of directors of the Company and the Bank, subject to any required regulatory and shareholder approvals. These designated directors each have the right to be appointed to two committees of each board of directors. We do not expect the governance rights under the Investment Agreements to terminate in connection with this offering. See “Certain Relationships and Related Party Transactions—Certain Related Party Transactions—Investment Agreements” for additional information.

We have broad discretion in the use of the net proceeds to us from this offering, and our use of these proceeds may not yield a favorable return on your investment.

We intend to use the net proceeds to us from this offering to support our growth, organically or through mergers and acquisitions, and for general corporate purposes, which may include the repayment or refinancing of

 

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debt and maintenance of our required regulatory capital levels. We have not specifically allocated the amount of net proceeds to us that will be used for these purposes and our management will have broad discretion over how these proceeds are used and could spend these proceeds in ways with which you may not agree. In addition, we may not use the net proceeds to us from this offering effectively or in a manner that increases our market value or enhances our profitability. We have not established a timetable for the effective deployment of the net proceeds to us, and we cannot predict how long it will take to deploy these proceeds. Until we deploy the proceeds of this offering for the uses described herein, we expect to hold such proceeds in short-term investments. Investing the net proceeds to us in short-term investments will provide lower yields than we generally earn on loans, which may have an adverse effect on our profitability. Although we may, from time to time in the ordinary course of business, evaluate potential acquisition opportunities that we believe provide attractive risk-adjusted returns, we do not have any arrangements or understandings relating to any acquisitions, nor are we engaged in negotiations with any potential acquisition targets. We will not receive any proceeds from the sale of shares of our common stock by the selling shareholders.

The holders of our existing debt obligations, as well as debt obligations that may be outstanding in the future, will have priority over our common stock with respect to payment in the event of liquidation, dissolution or winding up and with respect to the payment of interest.

In the event of any liquidation, dissolution or winding up of the Company, our common stock would rank below all claims of debt holders against us. As of March 31, 2018, we had outstanding $10.0 million of subordinated debt and $3.6 million in aggregate principal amount of junior subordinated debentures issued to a statutory trust that, in turn, has issued and outstanding $3.5 million of trust preferred securities. Payments of the principal and interest on the trust preferred securities are conditionally guaranteed by us. Our debt obligations are senior to our shares of common stock. In the event of our bankruptcy, dissolution or liquidation, the holders of our debt obligations must be satisfied before any distributions can be made to the holders of our common stock. We generally have the right to defer distributions on our junior subordinated debentures (and the related trust preferred securities) for up to five years, during which time no dividends may be paid to holders of our common stock. To the extent that we issue additional debt obligations or junior subordinated debentures, the additional debt obligations or additional junior subordinated debentures will be of equal rank with, or senior to, our existing debt obligations and senior to our shares of common stock.

We may issue shares of preferred stock in the future, which could make it difficult for another company to acquire us or could otherwise adversely affect holders of our common stock, which could depress the price of our common stock.

Our articles of incorporation authorize us to issue up to 25,000,000 shares of one or more series of preferred stock. Our board of directors will have the authority to determine the preferences, limitations and relative rights of shares of preferred stock and to fix the number of shares constituting any series and the designation of such series, without any further vote or action by our shareholders. Our preferred stock could be issued with voting, liquidation, dividend and other rights superior to the rights of our common stock. The potential issuance of preferred stock may delay or prevent a change in control of us, discourage bids for our common stock at a premium over the market price and materially adversely affect the market price and the voting and other rights of the holders of our common stock.

We are dependent upon the Bank for cash flow, and the Bank’s ability to make cash distributions is restricted.

Our primary tangible asset is the capital stock of the Bank. As such, we depend upon the Bank for cash distributions (through dividends on the Bank’s common stock) that we use to pay our operating expenses, satisfy our obligations (including our subordinated debentures and our other debt obligations). Federal statutes, regulations and policies restrict the Bank’s ability to make cash distributions to us. These statutes and regulations require, among other things, that the Bank maintain certain levels of capital in order to pay a dividend. Further, the Federal Reserve has the ability to restrict the Bank’s payment of dividends by supervisory action. If the Bank is unable to pay dividends to us, we will not be able to satisfy our obligations.

 

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We are an emerging growth company and we cannot be certain if the reduced disclosure requirements applicable to emerging growth companies will make our common stock less attractive to investors.

We are an “emerging growth company,” as defined in the JOBS Act, and we may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies, including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved. In addition, even if we comply with the greater obligations of public companies that are not emerging growth companies immediately after this offering, we may avail ourselves of the reduced requirements applicable to emerging growth companies from time to time in the future, so long as we are an emerging growth company. We will remain an emerging growth company for up to five years, though we may cease to be an emerging growth company earlier under certain circumstances, including if, before the end of such five years, we are deemed to be a large accelerated filer under the rules of the SEC (which depends on, among other things, having a market value of common stock held by non-affiliates in excess of $700 million) or if our total annual gross revenues equal or exceed $1.07 billion in a fiscal year. We cannot predict if investors will find our common stock less attractive because we will rely on these exemptions. If some investors find our common stock less attractive as a result, there may be a less active trading market for our common stock and the price of our common stock may be more volatile.

Further, the JOBS Act exempts emerging growth companies from being required to comply with new or revised financial accounting standards until private companies (that is, those that have not had a registration statement under the Securities Act of 1933, or the Securities Act, declared effective or do not have a class of securities registered under the Securities Exchange Act of 1934, or the Exchange Act) are required to comply with the new or revised financial accounting standards. The JOBS Act provides that a company can elect to opt out of the extended transition period and comply with the requirements that apply to non-emerging growth companies but any such an election to opt out is irrevocable. We have irrevocably opted out of such extended transition period, which means that when a standard is issued or revised and it has different application dates for public or private companies, we will adopt the new or revised standard at the time public companies adopt the new or revised standard.

Being a public company will increase our expenses and administrative workload and will expose us to risks relating to evaluation of our internal controls over financial reporting required by Section 404 of the Sarbanes-Oxley Act.

As a public company, we will need to comply with additional laws and regulations, including the Sarbanes-Oxley Act, the Dodd-Frank Act, and related rules of the SEC and requirements of the Nasdaq Stock Market. We were not required to comply with these laws and requirements as a private company. Complying with these laws and regulations will require the time and attention of our board of directors and management and will increase our expenses. Among other things, we will need to: design, establish, evaluate and maintain a system of internal controls over financial reporting in compliance with the requirements of Section 404 of the Sarbanes-Oxley Act and the related rules and regulations of the SEC and the Public Company Accounting Oversight Board; prepare and distribute periodic reports in compliance with our obligations under the federal securities laws; establish new internal policies, principally those relating to disclosure controls and procedures and corporate governance; institute a more comprehensive compliance function; and involve to a greater degree our outside legal counsel and accountants in the above activities.

In addition, we also expect that being a public company will make it more expensive for us to obtain director and officer liability insurance. We may be required to accept reduced coverage or incur substantially higher costs to obtain this coverage. These factors could also make it more difficult for us to attract and retain qualified executives and members of our board of directors, particularly directors willing to serve on our audit committee.

 

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We are in the process of evaluating our internal control systems to allow management to report on, and our independent auditors to assess, our internal controls over financial reporting. We plan to perform the system and process evaluation and testing (and any necessary remediation) required to comply with the management certification requirements of Section 404 of the Sarbanes-Oxley Act. We are required to comply with Section 404 in our annual report for the year ending December 31, 2019. However, we cannot be certain as to the timing of completion of our evaluation, testing and remediation actions or the impact of the same on our operations. Furthermore, upon completion of this process, we may identify control deficiencies of varying degrees of severity under applicable SEC and Public Company Accounting Oversight Board rules and regulations that remain unremediated.

If we fail to implement the requirements of Section 404 in a timely manner, we might be subject to sanctions or investigation by regulatory agencies such as the SEC. In addition, failure to comply with Section 404 or the report by us of a material weakness may cause investors to lose confidence in our financial statements or the trading price of our common stock to decline. If we fail to remediate any material weakness, our financial statements may be inaccurate, our access to the capital markets may be restricted and the trading price of our common stock may decline.

As a public company, we will be required to report, among other things, control deficiencies that constitute a “material weakness” or changes in internal controls that materially affect, or are reasonably likely to materially affect, internal controls over financial reporting. A “control deficiency” exists when the design or operation of a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent or detect misstatements on a timely basis. A “significant deficiency” is a control deficiency, or combination of control deficiencies, that adversely affects the ability to initiate, authorize, record, process or report financial data reliably in accordance with generally accepted accounting principles that results in more than a remote likelihood that a misstatement of financial statements that is more than inconsequential will not be prevented or detected. A “material weakness” is a significant deficiency, or a combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.

Provisions in our executive officers’ employment agreements could impede an attempt to replace or remove our officers or otherwise effect a change of control, which could diminish the price of our common stock.

We have entered into employment agreements with certain of our executive officers as described in the section entitled “Executive Compensation—Employment and Change in Control Agreements with Executive Officers.” The agreements with our executive officers provide for substantial payments in the event of certain types of termination of employment following a change in control. These payments may deter any transaction that would result in a change in control, which could diminish the price of our common stock.

Our corporate organizational documents and provisions of federal and state law to which we are subject contain certain provisions that could have an anti-takeover effect and may delay, make more difficult or prevent an attempted acquisition that you may favor or an attempted replacement of our board of directors or management.

Our articles of incorporation and our amended and restated bylaws, or bylaws, may have an anti-takeover effect and may delay, discourage or prevent an attempted acquisition or change of control or a replacement of our incumbent board of directors or management. Our governing documents include provisions that:

 

    empower our board of directors, without shareholder approval, to issue our preferred stock, the terms of which, including voting power, are to be set by our board of directors;

 

    establish a classified board of directors, with directors of each class serving a three-year term upon completion of a phase-in period;

 

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    provide that directors may be removed from office without cause only by vote of 80% of the outstanding shares then entitled to vote;

 

    eliminate cumulative voting in elections of directors;

 

    permit our board of directors to alter, amend or repeal our bylaws or to adopt new bylaws;

 

    require the request of holders of at least one-third of the outstanding shares of our capital stock entitled to vote at a meeting to call a special shareholders’ meeting;

 

    require shareholders that wish to bring business before annual meetings of shareholders, or to nominate candidates for election as directors at our annual meeting of shareholders, to provide timely notice of their intent in writing;

 

    require that certain business combination transactions with a significant shareholder be approved by holders of two-thirds of the shares held by persons other than the significant shareholder; and

 

    enable our board of directors to increase, between annual meetings, the number of persons serving as directors and to fill the vacancies created as a result of the increase by a majority vote of the directors present at a meeting of directors.

In addition, certain provisions of Washington law, including a provision which restricts certain business combinations between a Washington corporation and certain affiliated shareholders, may delay, discourage or prevent an attempted acquisition or change in control. Furthermore, banking laws impose notice, approval, and ongoing regulatory requirements on any shareholder or other party that seeks to acquire direct or indirect “control” of an FDIC-insured depository institution or its holding company. These laws include the Bank Holding Company Act of 1956, as amended, or the BHC Act, and the Change in Bank Control Act, or the CBCA. These laws could delay or prevent an acquisition.

Furthermore, our bylaws provide that a state court located within the state of Washington (or, if no state court located within the state of Washington has jurisdiction, the United States District Court for the Western District of Washington) will be the exclusive forum for: (a) any actual or purported derivative action or proceeding brought on our behalf; (b) any action asserting a claim of breach of fiduciary duty by any of our directors or officers; (c) any action asserting a claim against us or our directors or officers arising pursuant to the Washington Business Corporation Act, or WBCA, our articles of incorporation, or our bylaws; or (d) any action asserting a claim against us or our officers or directors that is governed by the internal affairs doctrine. By becoming a shareholder of our Company, you will be deemed to have notice of and have consented to the provisions of our bylaws related to choice of forum. The choice of forum provision in our bylaws may limit our shareholders’ ability to obtain a favorable judicial forum for disputes with us. Alternatively, if a court were to find the choice of forum provision contained in our bylaws to be inapplicable or unenforceable in an action, we may incur additional costs associated with resolving such action in other jurisdictions, which could adversely affect our business, financial condition and earnings.

The return on your investment in our common stock is uncertain.

An investor in our common stock may not realize a substantial positive return on his or her investment, or may not realize any positive return at all. Further, as a result of the uncertainty and risks associated with our operations, many of which are described in this “Risk Factors” section, it is possible that an investor could lose his or her entire investment.

An investment in our common stock is not an insured deposit and is subject to risk of loss.

Any shares of our common stock you purchase in this offering will not be savings accounts, deposits or other obligations of any of our bank or nonbank subsidiaries and will not be insured or guaranteed by the FDIC or any other government agency. Your investment will be subject to investment risk, and you must be capable of affording the loss of your entire investment.

 

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CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This prospectus contains forward-looking statements. These forward-looking statements reflect our current views with respect to, among other things, future events and our financial performance. Any statements about our management’s expectations, beliefs, plans, predictions, forecasts, objectives, assumptions or future events or performance are not historical facts and may be forward-looking. These statements are often, but not always, made through the use of words or phrases such as “anticipate,” “believes,” “can,” “could,” “may,” “predicts,” “potential,” “should,” “will,” “estimate,” “plans,” “projects,” “continuing,” “ongoing,” “expects,” “intends” and similar words or phrases. Any or all of the forward-looking statements in this prospectus may turn out to be inaccurate. The inclusion of forward-looking information in this prospectus should not be regarded as a representation by us or any other person that the future plans, estimates or expectations contemplated by us will be achieved. We have based these forward-looking statements largely on our current expectations and projections about future events and financial trends that we believe may affect our financial condition, results of operations, business strategy and financial needs. Our actual results could differ materially from those anticipated in such forward-looking statements as a result of several factors more fully described under the caption “Risk Factors” and elsewhere in this prospectus, as well as the following factors:

 

    the overall health of the local and national real estate market;

 

    the credit risk associated with our loan portfolio, and specifically with our commercial real estate loans;

 

    business and economic conditions generally and in the financial services industry, nationally and within our market area;

 

    our ability to maintain an adequate level of allowance for loan losses;

 

    our ability to successfully manage liquidity risk;

 

    our ability to implement our growth strategy and manage costs effectively;

 

    the composition of our senior leadership team and our ability to attract and retain key personnel;

 

    our ability to raise additional capital to implement our business plan;

 

    changes in market interest rates and impacts of such changes on our profits and business;

 

    the occurrence of fraudulent activity, breaches or failures of our information security controls or cybersecurity-related incidents;

 

    interruptions involving our information technology and telecommunications systems or third-party servicers;

 

    our ability to maintain our reputation;

 

    increased competition in the financial services industry;

 

    regulatory guidance on commercial lending concentrations;

 

    the effectiveness of our risk management framework;

 

    the costs and obligations associated with being a public company;

 

    the commencement and outcome of litigation and other legal proceedings and regulatory actions against us or to which we may become subject;

 

    the extensive regulatory framework that applies to us;

 

    the impact of recent and future legislative and regulatory changes, including the Tax Cuts and Jobs Act, the EGRRCPA, and other changes in banking, securities and tax laws and regulations, and their application by our regulators;

 

    fluctuations in the value of the securities held in our securities portfolio;

 

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    governmental monetary and fiscal policies;

 

    material weaknesses in our internal control over financial reporting; and

 

    our success at managing the risks involved in the foregoing items.

The foregoing factors should not be construed as exhaustive and should be read together with the other cautionary statements included in this prospectus. If one or more events related to these or other risks or uncertainties materialize, or if our underlying assumptions prove to be incorrect, actual results may differ materially from what we anticipate. You are cautioned not to place undue reliance on forward-looking statements. Further, any forward-looking statement speaks only as of the date on which it is made and we undertake no obligation to update or revise any forward-looking statement to reflect events or circumstances after the date on which the statement is made or to reflect the occurrence of unanticipated events.

 

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USE OF PROCEEDS

We estimate that the net proceeds to us from this offering, after deducting underwriting discounts and estimated offering expenses payable by us, will be approximately $            million (or approximately $            million if the underwriters exercise in full their option to purchase additional shares), based on an assumed initial public offering price of $            per share, which is the midpoint of the price range set forth on the cover page of this prospectus. Each $1.00 increase (decrease) in the assumed initial public offering price would increase (decrease) the net proceeds to us of this offering by $            million, or $            million if the underwriters exercise in full their option to purchase additional shares, after deducting underwriting discounts and estimated offering expenses payable by us.

We intend to contribute a substantial portion of the net proceeds to us from this offering to the Bank and to initially retain the remaining net proceeds we will receive from this offering in the Company. We intend to use the net proceeds to us from this offering to support our growth, organically or through mergers and acquisitions, and for general corporate purposes, which may include the repayment or refinancing of debt and maintenance of our required regulatory capital levels. Except as described herein, we do not currently have any specific plans for the application of the net proceeds to us and do not have any arrangements or understandings to make any acquisitions or to establish any new branches. Our management will retain broad discretion to allocate the net proceeds of this offering, and the precise amounts and timing of our use of the net proceeds will depend upon market conditions, among other factors. Until we deploy the proceeds of this offering for the uses described above, we expect to hold such proceeds in short-term investments.

We will not receive any proceeds from the sale of shares of our common stock by the selling shareholders.

 

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DIVIDEND POLICY

General

Holders of our common stock are only entitled to receive dividends when, as and if declared by our board of directors out of funds legally available for dividends. We have not historically declared or paid dividends on our common stock and we do not intend to declare or pay dividends on our common stock in the near-term. Instead, we anticipate that all of our future earnings will be retained to support our operations and to finance the growth and development of our business. Any future determination to pay dividends will be made by our board of directors and will depend on a number of factors, including:

 

    our historic and projected financial condition, liquidity and results of operations;

 

    our capital levels and needs;

 

    tax considerations;

 

    any acquisitions or potential acquisitions that we may pursue;

 

    statutory and regulatory prohibitions and other limitations;

 

    the terms of any credit agreements or other borrowing arrangements that restrict our ability to pay cash dividends;

 

    general economic conditions; and

 

    other factors that our board of directors may deem relevant.

We are not obligated to pay dividends on our common stock and are subject to certain restrictions on paying dividends on our common stock.

Dividend Restrictions

As a Washington corporation, we are subject to certain restrictions on distributions to shareholders under the WBCA. Generally, a Washington corporation is prohibited from making a distribution to shareholders if, after giving effect to the distribution, the corporation would not be able to pay its liabilities as they become due in the usual course of business or the corporation’s total assets would be less than the sum of its total liabilities plus, unless its articles of incorporation provide otherwise, the amount that would be needed, if the corporation were to be dissolved at the time of the distribution, to satisfy the preferential rights upon dissolution of shareholders whose preferential rights are superior to those receiving the distribution. In addition, if required payments on our outstanding junior subordinated debentures are not made or suspended, we may be prohibited from paying dividends on our common stock. We are also subject to certain restrictions on our right to pay dividends on our capital stock in the event we have failed to make any required payment of interest or principal under the terms of our subordinated note.

We are subject to certain restrictions on the payment of cash dividends as a result of banking laws, regulations and policies. Because we are a bank holding company and do not engage directly in business activities of a material nature, our ability to pay dividends on our common stock depends, in large part, upon our receipt of dividends from the Bank, which is also subject to numerous limitations on the payment of dividends under federal and state banking laws, regulations and policies. See “Supervision and Regulation—Bank Regulation and Supervision—Payment of Dividends.” The present and future dividend policy of the Bank is subject to the discretion of its board of directors. The Bank is not obligated to pay us dividends.

 

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CAPITALIZATION

The following table sets forth our consolidated capitalization and regulatory capital ratios at March 31, 2018:

 

    on an actual basis; and

 

    on an adjusted basis, after giving effect to the net proceeds from the sale by us of shares of common stock in this offering (assuming the underwriters do not exercise their option to purchase additional shares) at an assumed initial public offering price of $             per share, which is the midpoint of the price range set forth on the cover page of this prospectus, after deducting underwriting discounts and estimated offering expenses payable by us.

You should read the information in this table in conjunction with the sections entitled “Use of Proceeds,” “Selected Historical Consolidated Financial Data,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Description of Capital Stock” and our consolidated financial statements and related notes to those financial statements included elsewhere in this prospectus. The outstanding share and per share data set forth in the following table have been adjusted to give effect to a one-for-five reverse stock split of our common shares completed effective May 4, 2018.

 

     At
March 31, 2018
 
(Dollars in thousands, except per share data)    Actual     As Adjusted  

Long-Term Debt:

    

Subordinated debt

   $ 9,954     $ 9,954  

Junior subordinated debentures

     3,580       3,580  
  

 

 

   

 

 

 

Total long-term debt

     13,534       13,534  
  

 

 

   

 

 

 

Shareholders’ Equity:

    

Preferred stock, no par value, 25,000,000 shares authorized; none issued and outstanding

     -       -  

Common stock, no par value, 300,000,000 shares authorized, 8,891,859 voting and 361,444 nonvoting shares issued and outstanding, actual;             voting and             nonvoting shares issued and outstanding, as adjusted

     52,592    

Retained earnings

     16,163       16,163  

Accumulated other comprehensive loss, net of tax

     (1,828     (1,828
  

 

 

   

 

 

 

Total shareholders’ equity

     66,927    
  

 

 

   

 

 

 

Total capitalization

   $ 80,461    

Capital Ratios: (1)

    

Total shareholders’ equity to total assets

     8.05  

Tangible equity to tangible assets (2)

     8.05  

Common equity tier 1 capital ratio

     9.75  

Tier 1 leverage ratio

     9.07  

Tier 1 risk-based capital ratio

     10.25  

Total risk-based capital ratio

     12.90  

Non-owner occupied CRE/total capital (3)

     366.83  

Per Share Data: (4)

    

Book value per share

   $ 7.23    

Tangible book value per share (5)

   $ 7.23    

 

(1) Except as otherwise noted, capital ratios are for the Company.
(2)

Tangible equity to tangible assets is a non-GAAP financial measure. The most directly comparable GAAP financial measure is total shareholders’ equity to total assets. The Company had no goodwill or other

 

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  intangible assets as of the date indicated. As a result, tangible equity to tangible assets is the same as total shareholders’ equity to total assets as of the date indicated.
(3) Ratio is for the Bank and represents total non-owner-occupied commercial real estate loans, including loans secured by multi-family residential real estate, investor commercial real estate, and construction and land loans, divided by the Bank’s total risk-based capital. The ratio, as adjusted, assumes that all of the net proceeds to us from this offering will be contributed to the Bank; however, it is not currently known how the proceeds from this offering will be allocated. See “Use of Proceeds.”
(4) Per share amounts are based on total common shares outstanding, which includes common stock and nonvoting common stock.
(5) Tangible book value per share is a non-GAAP financial measure. The most directly comparable GAAP financial measure is book value per share. The Company had no goodwill or other intangible assets as of the date indicated. As a result, tangible book value per share is the same as book value per share as of the date indicated.

Each $1.00 increase (decrease) in the assumed initial public offering price of $             per share, which is the midpoint of the price range set forth on the cover page of this prospectus, would increase (decrease) our total shareholders’ equity and total capitalization by approximately $             million, assuming the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same and after deducting underwriting discounts and estimated offering expenses payable by us.

 

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DILUTION

If you purchase shares of our common stock in this offering, your ownership interest will experience immediate tangible book value dilution to the extent that the initial public offering price per share of our common stock exceeds the tangible book value per share of our common stock immediately following this offering. Tangible book value per share is equal to our total shareholders’ equity, less goodwill and other intangible assets, divided by the number of outstanding common shares, which includes common stock and nonvoting common stock. The per share data set forth below have been adjusted to give effect to a one-for-five reverse stock split of our common shares effective May 4, 2018.

Our tangible book value at March 31, 2018, was $66.9 million, or $7.23 per share based on the total number of shares of common stock and nonvoting common stock outstanding as of such date. After giving effect to our sale of             shares of common stock in this offering (assuming the underwriters do not exercise their option to purchase additional shares) at an assumed initial public offering price of $             per share, which is the midpoint of the price range on the cover page of this prospectus, and after deducting underwriting discounts and estimated offering expenses payable by us, our as adjusted tangible book value at March 31, 2018, would have been approximately $             million, or $             per share. Therefore, under those assumptions this offering would result in an immediate increase of $             in the tangible book value per share to our existing shareholders, and immediate dilution of $             in the tangible book value per share to investors purchasing shares of common stock in this offering.

The following table illustrates this dilution on a per share basis:

 

Assumed initial public offering price per share

     

Tangible book value per share as of March 31, 2018

   $ 7.23     

Increase in tangible book value per share attributable to this offering

     
  

 

 

    

Tangible book value per share after giving effect to this offering

     
     

 

Dilution in tangible book value per share to new investors in this offering

     
     

 

A $1.00 increase (decrease) in the assumed initial public offering price of $            per share, which is the midpoint of the price range on the cover page of this prospectus, would increase (decrease) our tangible book value by $            million, or $            per share, and the dilution to new investors in this offering would increase (decrease) by $            per share, assuming no change to the number of shares of common stock offered by us as set forth on the cover page of this prospectus, and after deducting underwriting discounts and estimated offering expenses payable by us.

If the underwriters exercise in full their option to purchase additional shares of common stock from us, our as adjusted tangible book value after giving effect to this offering would be $            per share. This represents an increase in tangible book value of $            per share to existing shareholders and dilution of $            per share to new investors in this offering.

 

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The following table sets forth information, as of March 31, 2018, regarding the shares of common stock and nonvoting common stock issued to, and consideration paid by, the existing holders of shares of common stock and nonvoting common stock and the shares of common stock to be issued to, and consideration to be paid by, investors in this offering (assuming the underwriters do not exercise their option to purchase additional shares) at an assumed initial public offering price of $            per share, which is the midpoint of the price range on the cover page of this prospectus, before deducting underwriting discounts and estimated offering expenses payable by us.

 

     Shares Issued     Total
Consideration
    Average
Price per
Share
 
     Number      Percent     Amount      Percent    

Existing shareholders

     9,253,303            

New investors in this offering

            
  

 

 

    

 

 

   

 

 

    

 

 

   

Total

        100.0        100.0  

Assuming no shares are sold to existing shareholders in this offering, sales of shares of our common stock by the selling shareholders in this offering will reduce the number of shares of common stock held by existing shareholders to             , or approximately     % of the total shares of our common stock outstanding after this offering, and will result in new investors holding              shares, or approximately     % of the total shares of our common stock outstanding after this offering.

The tables and calculations above do not give effect to:

 

    784,984 shares of our common stock issuable upon the exercise of stock options, with a weighted average exercise price of $6.27 per share, that were outstanding as of March 31, 2018; and

 

    500,000 additional shares of our common stock that are reserved for future issuance under our 2018 Omnibus Incentive Plan.

To the extent that any of the outstanding stock options are exercised or other equity awards are issued under our incentive plans, investors participating in this offering will experience further dilution.

 

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PRICE RANGE OF OUR COMMON STOCK

Prior to this offering, our common stock has not been traded on an established public trading market and quotations for our common stock were not reported on any market. As a result, there has been no regular trading market for our common stock. Although our shares may have been sporadically traded in private transactions, the prices at which such transactions occurred may not necessarily reflect the price that would be paid for our common stock in an active market. As of March 31, 2018, there were 575 holders of record of our common stock.

We anticipate that this offering and the listing of our common stock on the Nasdaq Global Select Market will result in a more active trading market for our common stock. However, we cannot assure you that a liquid trading market for our common stock will develop or be sustained after this offering. You may not be able to sell your shares quickly or at the market price if trading in our common stock is not active. See “Underwriting (Conflicts of Interest)” for more information regarding our arrangements with the underwriters and the factors considered in setting the initial public offering price.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with “Selected Historical Consolidated Financial Data” and our consolidated financial statements and the related notes to those financial statements included elsewhere in this prospectus. This discussion and analysis contains forward-looking statements that are subject to certain risks and uncertainties and are based on certain assumptions that we believe are reasonable but may prove to be inaccurate. Certain risks, uncertainties and other factors, including those set forth under “Cautionary Note Regarding Forward-Looking Statements,” “Risk Factors” and elsewhere in this prospectus, may cause actual results to differ materially from those projected results discussed in the forward-looking statements appearing in this discussion and analysis. We assume no obligation to update any of these forward-looking statements. Unless otherwise stated, all information in this prospectus gives effect to a one-for-five reverse stock split of our common shares effective May 4, 2018. The effect of the reverse stock split on outstanding shares and per share figures has been retroactively applied to all periods presented.

Overview

We are a bank holding company that operates through our wholly owned subsidiary, Coastal Community Bank. We are headquartered in Everett, Washington, which by population is the largest city in, and the county seat of, Snohomish County. We focus on providing a wide range of banking products and services to consumers and small to medium sized businesses in the broader Puget Sound region in the state of Washington. We currently operate 13 full-service banking locations, 10 of which are located in Snohomish County, where we are the largest community bank by deposit market share, and three of which are located in neighboring counties (one in King County and two in Island County). As of March 31, 2018, we had total assets of $831.0 million, total loans of $678.5 million, total deposits of $727.3 million and total shareholders’ equity of $66.9 million.

The following discussion and analysis presents our financial condition and results of operations on a consolidated basis. However, because we conduct all of our material business operations through Coastal Community Bank, the discussion and analysis relate to activities primarily conducted by the Bank.

As a bank holding company that operates through one segment, community banking, we generate most of our revenue from interest on loans and investments. Our primary source of funding for our loans is commercial and retail deposits. We place secondary reliance on wholesale funding, primarily borrowings from the Federal Home Loan Bank, or FHLB. Our largest expenses are salaries and related employee benefits, occupancy, interest on deposits and borrowings, data processing, and provision for loan losses. Our principal lending products are commercial real estate loans, commercial and industrial loans, and to a lesser extent residential real estate loans and consumer loans.

Key Factors Affecting our Business

Average Balances and Interest Rates

Our operating results depend primarily on our net interest income, which is the largest contributor to our net income and is the difference between the interest and fees earned on interest-earning assets (such as loans and securities) and the interest expense incurred in connection with interest-bearing liabilities (such as deposits and borrowings). Net interest income is primarily a function of the average balances of interest-earning assets and interest-bearing liabilities and the yields and costs with respect to these assets and liabilities. Average balances are influenced by internal considerations such as the types of products we offer and the amount of risk that we are willing to assume as well as external influences such as economic conditions, competition for loans and deposits, and interest rates. The yields generated by our loans and securities are typically affected by short-term and long-term interest rates and, in the case of loans, competition for similar products in our market area. Interest

 

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rates are often impacted by the actions of the Federal Reserve. The cost of our deposits and short-term borrowings is primarily based on short-term interest rates, which are largely driven by competition and by the actions of the Federal Reserve. The level of net interest income is influenced by movements in interest rates and the pace at which such movements occur, as well as the relationship between short- and long-term interest rates.

Credit Quality

We have well established loan policies and underwriting practices that have resulted in low levels of charge-offs and nonperforming assets. Through our thorough underwriting process, we strive to originate quality loans that will maintain and enhance the overall credit quality of our loan portfolio, and through our careful monitoring of our loan portfolio and prompt attention to delinquencies, we seek to minimize the impact of problem loans. However, credit trends in the markets in which we operate are largely impacted by economic conditions beyond our control and can adversely impact our financial condition.

Operating Efficiency

Our largest noninterest expense is salaries and employee benefits, which consist primarily of salaries and wages paid to our employees, payroll taxes, and expenses for health insurance, retirement plans and other employee benefits. Other significant operating expenses include occupancy expense, data processing expense, director and staff expense, marketing expense, and legal and professional fees. Our operating efficiency, as measured by our efficiency ratio, has gradually improved primarily because the growth of our deposits and loans has enabled our net interest income and noninterest income to outpace our expenses. When we open new branches or make substantial investments to increase our operating capacity, our operating efficiency decreases until we generate enough growth to offset the increased costs however, prior to making such investments, we focus on how best and most expediently we can achieve the growth necessary to offset the costs of these investments or new branches.

Economic Conditions

Our business and financial performance are affected by economic conditions generally in the United States and more directly in the markets in the Puget Sound region where we operate. The significant economic factors that are most relevant to our business and our financial performance include, but are not limited to, real estate values, interest rates and unemployment rates. In recent years, the Puget Sound region has experienced significant population gain, fueled in large part by the region’s technology industry, low unemployment and rising real estate values, all of which positively impacted our business.

Results of Operations

Net Income

Three Months Ended March 31, 2018, Compared to Three Months Ended March 31, 2017. Net income for the three months ended March 31, 2018, was $1.8 million, or $0.20 per diluted share, compared to $1.3 million, or $0.14 per diluted share, for the three months ended March 31, 2017. The increase in net income over the comparable period in the prior year was attributable to a $903,000 increase in net interest income, primarily arising from increased interest-earning assets from our loan growth initiatives, as well as a $269,000 increase in fee income from raising our deposit service charges and fees and revenue from loan referral fees and $104,000 in lower taxes resulting from the decrease in the corporate tax rate under the Tax Cuts and Jobs Act. These positive factors were partially offset by a $691,000 increase in noninterest expense.

Year Ended December 31, 2017, Compared to Year Ended December 31, 2016. Net income for the year ended December 31, 2017, was $5.4 million, or $0.59 per diluted share, compared to $5.0 million, or $0.54 per diluted share, for the year ended December 31, 2016. Net income for 2017 included the impact of $1.3 million in

 

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additional income tax expense that resulted from the revaluation of deferred tax assets as a result of the reduction in the corporate income tax rate under the Tax Cuts and Jobs Act. Adjusted net income, which excludes the effect of the additional income tax expense, for the year ended December 31, 2017, was $6.7 million, or $0.73 per diluted share. See “GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures.” The increase in net income over the prior year was attributable to a $3.3 million increase in net interest income and a $1.0 million decrease in the provision for loan losses, which were partially offset by an $823,000 decrease in noninterest income and an $895,000 increase in noninterest expense.

Net Interest Income

Three Months Ended March 31, 2018, Compared to Three Months Ended March 31, 2017. Net interest income for the three months ended March 31, 2018, was $7.8 million compared to $6.9 million for the three months ended March 31, 2017, an increase of $903,000, or 13.1%. The increase in net interest income consisted of a $1.1 million, or 14.1%, increase in interest income offset by a $161,000, or 24.1%, increase in interest expense.

The growth in interest income was primarily attributable to a $56.6 million, or 9.5%, increase in average loans outstanding for the three months ended March 31, 2018, compared to the prior year, combined with a 14 basis point increase in the yield on total loans. We have continued to focus on our loan growth initiatives, including the deepening of relationships with existing customers and developing new loan and deposit relationships. We have also focused on organically growing loans through our existing lenders and by adding new lenders to assist with our efforts.

The increase in interest expense for the three months ended March 31, 2018, was primarily related to a 9 basis point increase in the cost of interest-bearing deposits combined with a $39.4 million, or 9.3%, increase in average interest-bearing deposits over the same period in the prior year. The increase in the cost of deposits was primarily due to an increase in the rate paid on NOW and money market accounts and on time deposits, as market interest rates increased over the prior year. The increase in average interest-bearing deposits for the three months ended March 31, 2018, compared to the same period in 2017 is attributable to growth in all deposit categories. The average balance of NOW and money market accounts grew $17.0 million, or 5.5%, the average balance of savings accounts grew $6.6 million, or 16.9%, and the average balance of customer time deposits grew $15.7 million, or 21.4%. We do not regularly advertise time deposit rates or money market rates, although we occasionally advertise promotional rates in targeted portions of our market area. Our branch managers, business development officers, and lenders collaborate to provide consistent and coordinated customer service and to seek deposits from new and existing customers.

For the three months ended March 31, 2018, net interest margin (annualized net interest income divided by average total interest-earning assets) and net interest spread (average yield on total interest-earning assets minus average cost of total interest-bearing liabilities) were 4.12% and 3.86%, respectively, compared to 4.01% and 3.78% for the three months ended March 31, 2017.

 

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The following table presents an analysis of net interest income, net interest spread and net interest margin for the periods indicated. Loan fees included in interest income totaled $311,000 and $119,000 for the three months ended March 31, 2018 and 2017, respectively. For the three months ended March 31, 2018 and 2017, the amount of interest income not recognized on nonaccrual loans was not material.

 

     For the Three Months Ended March 31,  
     2018     2017  
(Dollars in thousands)    Average
Balance
    Interest &
Dividends
     Yield /
Cost (4)
    Average
Balance
    Interest &
Dividends
     Yield /
Cost (4)
 

Assets:

              

Interest earning assets:

              

Interest-bearing deposits

   $ 68,160     $ 255        1.52   $ 58,706     $ 138        0.95

Investment securities, available for sale (1)

     38,341       146        1.54       34,634       117        1.37  

Investment securities, held to maturity (1)

     1,376       6        1.77       1,751       1        0.23  

Other investments

     2,912       11        1.53       2,603       11        1.71  

Loans (2)

     654,570       8,189        5.07       597,991       7,277        4.94  
  

 

 

   

 

 

      

 

 

   

 

 

    

Total interest earning assets

     765,359       8,607        4.56       695,685       7,543        4.40  
  

 

 

   

 

 

      

 

 

   

 

 

    

Allowance for loan losses

     (8,121          (7,680     

Noninterest earning assets

     37,614            44,662       
  

 

 

        

 

 

      

Total assets

   $ 794,852          $ 732,667       

Liabilities and Shareholders’ Equity

              

Interest bearing liabilities:

              

Interest-bearing deposits

   $ 464,219       646        0.56   $ 424,852       494        0.47  

FHLB advances and other fed funds

     667       4        2.43       500       2        1.62  

Subordinated debt

     9,952       144        5.87       9,938       144        5.88  

Junior subordinated debentures

     3,579       35        3.97       3,578       28        3.17  
  

 

 

   

 

 

      

 

 

   

 

 

    

Total interest-bearing liabilities

     478,417       829        0.70       438,868       668        0.62  
  

 

 

   

 

 

      

 

 

   

 

 

    

Noninterest bearing deposits

     245,273            222,416       

Other liabilities

     2,971            2,918       

Total shareholders’ equity

     68,191            68,465       
  

 

 

        

 

 

      

Total liabilities and shareholders’ equity

   $ 794,852          $ 732,667       

Net interest income

     $ 7,778          $ 6,875     

Net interest spread

          3.86            3.78  

Net interest margin (3)

          4.12            4.01  

 

(1) For presentation in this table, average balances and the corresponding average rates for investment securities are based upon historical cost, adjusted for amortization of premiums and accretion of discounts.
(2) Includes nonaccrual loans.
(3) Net interest margin represents annualized net interest income divided by average total interest-earning assets.
(4) Yields and rates are annualized.

 

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The following table presents information regarding the dollar amount of changes in interest income and interest expense for the periods indicated for each major component of interest-earning assets and interest-bearing liabilities and distinguishes between the changes attributable to changes in volume and changes attributable to changes in interest rates. For purposes of this table, changes attributable to both rate and volume that cannot be segregated have been allocated to volume.

 

     Three Months Ended March 31, 2018
Compared to
Three Months Ended March 31, 2017
 
     Increase (Decrease)
Due to
    Total Increase
(Decrease)
 
(Dollars in thousands)    Volume     Rate    

Interest income:

      

Interest-bearing deposits

   $ 35     $ 82     $ 117  

Investment securities, available for sale

     13       16       29  

Investment securities, held to maturity

     (2     7       5  

Other investments

     1       (1     -  

Loans

     708       205       913  
  

 

 

   

 

 

   

 

 

 

Total increase (decrease) in interest income

     755       309       1,064  

Interest expense:

      

Interest-bearing deposits

     55       97       152  

FHLB advances

     1       1       2  

Subordinated debt

     -       1       1  

Junior subordinated debentures

     -       7       7  
  

 

 

   

 

 

   

 

 

 

Total increase (decrease) in interest expense

     56       106       162  

Increase (decrease) in net interest income

   $ 699     $ 203     $ 902  
  

 

 

   

 

 

   

 

 

 

Year Ended December 31, 2017, Compared to Year Ended December 31, 2016. Net interest income for the year ended December 31, 2017, was $29.2 million compared to $26.0 million for the year ended December 31, 2016, an increase of $3.2 million, or 12.3%. The increase in net interest income consisted of a $3.7 million, or 12.8%, increase in interest income offset by a $352,000, or 14.0%, increase in interest expense.

The growth in interest income was primarily attributable to a $84.3 million, or 15.8%, increase in average loans outstanding for the year ended December 31, 2017, compared to the prior year, partially offset by an 18 basis point decrease in the yield on total loans. The increase in average loans outstanding was primarily due to our dual strategies of focusing on deepening relationships with existing borrowers and actively calling on new customers. The hiring of additional lenders also contributed to loan growth, as new lenders were able to transition many of their existing customers and pending transactions to the Bank. The decline in the yield on total loans reflects the competitive nature of the markets in which we operate, as well as the decline in interest income on our construction, land, and land development loans, which is one of our highest yielding loan categories. In 2017, the robust real estate market in the Puget Sound region resulted in newly constructed homes selling quickly, enabling builders to repay their loans more quickly and resulting in our maintaining a lower balance of construction and development loans.

The increase in interest expense for the year ended December 31, 2017, was primarily related to a $47.1 million, or 12.2%, increase in average interest-bearing deposits over the prior year. The majority of this increase is attributable to growth in core deposit accounts, which we define as deposits excluding all time deposits. Noninterest bearing deposits (such as demand or checking accounts) grew $18.4 million, or 8.2%, in 2017. Savings, interest bearing checking, and money market accounts grew $22.7 million, or 6.5%, in 2017, while customer time deposits grew $13.5 million, or 17.5%. We do not regularly advertise time deposit rates or money market rates, although we occasionally advertise promotional rates in targeted portions of our market area. Our branch managers, business development officers, and lenders collaborate to provide consistent and coordinated customer service and to seek deposits from new and existing customers.

 

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For the year ended December 31, 2017, net interest margin and net interest spread were 4.08% and 3.83%, respectively, compared to 4.13% and 3.90% for the year ended December 31, 2016.

The following table presents an analysis of net interest income, net interest spread and net interest margin for the periods indicated. Loan fees included in interest income totaled $542,000 and $725,000 for the years ended December 31, 2017 and 2016, respectively. For the years ended December 31, 2017 and 2016, the amount of interest income not recognized on nonaccrual loans was not material.

 

     For the Year Ended December 31,  
     2017     2016  
(Dollars in thousands)    Average
Balance
    Interest &
Dividends
     Yield /
Cost
    Average
Balance
    Interest &
Dividends
     Yield /
Cost
 

Assets:

              

Interest earning assets:

              

Interest-bearing deposits

   $ 58,418     $ 666        1.14   $ 57,810     $ 402        0.70

Investment securities, available for sale (1)

     35,808       512        1.43       30,908       324        1.05  

Investment securities, held to maturity (1)

     1,640       22        1.34       2,023       40        1.98  

Other investments

     2,886       138        4.78       2,697       124        4.60  

Loans (2)

     618,452       30,775        4.98       534,186       27,570        5.16  
  

 

 

   

 

 

      

 

 

   

 

 

    

Total interest earning assets

     717,204       32,113        4.48       627,624       28,460        4.53  
  

 

 

   

 

 

      

 

 

   

 

 

    

Allowance for loan losses

     (7,849          (6,739     

Noninterest earning assets

     39,585            36,512       
  

 

 

        

 

 

      

Total assets

   $ 748,940          $ 657,397       

Liabilities and Shareholders’ Equity

              

Interest bearing liabilities:

              

Interest-bearing deposits

   $ 431,628       2,139        0.50   $ 384,566       2,118        0.55

FHLB advances and other fed funds

     1,761       27        1.53       5,814       51        0.88  

Subordinated debt

     9,943       587        5.90       4,244       252        5.94  

Junior subordinated debentures

     3,578       122        3.41       3,569       102        2.86  
  

 

 

   

 

 

      

 

 

   

 

 

    

Total interest-bearing liabilities

     446,910       2,875        0.64       398,193       2,523        0.63  
  

 

 

   

 

 

      

 

 

   

 

 

    

Noninterest bearing deposits

     233,054            197,779       

Other liabilities

     3,256            2,989       

Total shareholders’ equity

     65,720            58,436       
  

 

 

        

 

 

      

Total liabilities and shareholders’ equity

   $ 748,940          $ 657,397       

Net interest income

     $ 29,238          $ 25,937     

Net interest spread

          3.83            3.90  

Net interest margin (3)

          4.08            4.13  

 

(1) For presentation in this table, average balances and the corresponding average rates for investment securities are based upon historical cost, adjusted for amortization of premiums and accretion of discounts.
(2) Includes nonaccrual loans.
(3) Net interest margin represents net interest income divided by average total interest-earning assets.

 

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The following table presents information regarding the dollar amount of changes in interest income and interest expense for the periods indicated for each major component of interest-earning assets and interest-bearing liabilities and distinguishes between the changes attributable to changes in volume and changes attributable to changes in interest rates. For purposes of this table, changes attributable to both rate and volume that cannot be segregated have been allocated to volume.

 

     Year Ended December 31, 2017
Compared to
Year Ended December 31, 2016
 
     Increase (Decrease)
Due to
    Total Increase
(Decrease)
 
(Dollars in thousands)    Volume     Rate    

Interest income:

      

Interest-bearing deposits

   $ 7     $ 257     $ 264  

Investment securities, available for sale

     58       130       188  

Investment securities, held to maturity

     (5     (13     (18

Other investments

     9       5       14  

Loans

     4,193       (988     3,205  
  

 

 

   

 

 

   

 

 

 

Total increase (decrease) in interest income

     4,262       (609     3,653  

Interest expense:

      

Interest-bearing deposits

     233       (212     21  

FHLB advances

     (62     38       (24

Subordinated debt

     336       (1     335  

Junior subordinated debentures

     -       20       20  
  

 

 

   

 

 

   

 

 

 

Total increase (decrease) in interest expense

     507       (155     352  

Increase (decrease) in net interest income

   $ 3,755     $ (454   $ 3,301  
  

 

 

   

 

 

   

 

 

 

Provision for Loan Losses

The provision for loan losses is an expense we incur to maintain an allowance for loan losses at a level that is deemed appropriate by management to absorb inherent losses on existing loans. For a description of the factors taken into account by our management in determining the allowance for loan losses see “—Financial Condition—Allowance for Loan Losses.”

Three Months Ended March 31, 2018, Compared to Three Months Ended March 31, 2017. The provision for loan losses for the three months ended March 31, 2018, was $501,000, compared to $439,000 for the three months ended March 31, 2017. The increase of $62,000 was primarily due to loan growth. The allowance for loan losses as a percentage of loans was 1.24% at March 31, 2018, compared to 1.31% at March 31, 2017. The lower allowance that resulted from stronger credit quality reduced the amount of provision needed for 2018.

Net charge-offs for the three months ended March 31, 2018, totaled $95,000, or 0.06% (annualized) of total average loans, as compared to net charge-offs of $190,000, or 0.13% (annualized) of total average loans, for the three months ended March 31, 2017. Net charge-offs for both periods were low, and demonstrate the strong credit quality of our loan portfolio and a healthy economic environment in our market area.

Year Ended December 31, 2017, Compared to Year Ended December 31, 2016. The provision for loan losses for the year ended December 31, 2017, was $870,000, compared to $1.9 million for the year ended December 31, 2016. The decrease of $1.0 million was primarily due to loan growth totaling $60.7 million in 2017 compared to $96.9 million in 2016, as well as improved credit quality. The allowance for loan losses as a percentage of loans was 1.22% at December 31, 2017, compared to 1.27% at December 31, 2016. The lower allowance that resulted from stronger credit quality reduced the amount of provision needed for 2017.

 

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Net charge-offs for the year ended December 31, 2017, totaled $397,000, or 0.06% of total average loans, as compared to net charge-offs of $364,000, or 0.07% of total average loans, for the year ended December 31, 2016. Net charge-offs for both years were consistent on a percentage basis and were only slightly higher in 2017 as a result of higher loan balances.

Noninterest Income

Our primary sources of recurring noninterest income are deposit account service charges, loan referral fees, mortgage broker fees, and sublease and lease income. Noninterest income does not include loan origination fees to the extent they exceed the direct loan origination costs, which are generally recognized over the life of the related loan as an adjustment to yield using the interest method.

For the three months ended March 31, 2018, noninterest income totaled $1.1 million, an increase of $276,000, or 33.2%, compared to $831,000 for the three months ended March 31, 2017. For the year ended December 31, 2017, noninterest income totaled $4.2 million, a decrease of $823,000, or 16.5%, compared to $5.0 million for the year ended December 31, 2016.

The following table presents, for the periods indicated, the major categories of noninterest income:

 

     Three Months
Ended March 31,
     Increase
(Decrease)
    Percent
Change
    Year Ended
December 31,
     Increase
(Decrease)
    Percent
Change
 
(Dollars in thousands)    2018      2017          2017      2016       

Deposit service charges and fees

   $ 687      $ 548      $ 139       25.4   $ 2,617      $ 2,123      $ 494       23.3

Loan referral fees

     130        -        130       N/M       439        423        16       3.8  

Mortgage broker fees

     37        41        (4     (9.8     255        346        (91     (26.3

Sublease and lease income

     57        56        1       1.8       222        234        (12     (5.1

Gain on sale of loans, net

     64        26        38       146.2       102        790        (688     (87.1

Gain on sale of securities, net

     -        -        -       -       -        160        (160     (100.0

Other

     132        160        (28     (17.5     519        901        (382     (42.4
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

Total noninterest income

   $ 1,107      $ 831      $ 276       33.2   $ 4,154      $ 4,977      $ (823     (16.5 )% 
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

Deposit Service Charges and Fees. Deposit fees, which are fees from our customers for deposit-related services, constitute the largest component of our noninterest income. Service charges on deposit accounts were $687,000 for the three months ended March 31, 2018, an increase of $139,000, or 25.4%, over the same period in the prior year. Service charges on deposit accounts were $2.6 million for the year ended December 31, 2017, an increase of $494,000, or 23.3%, over the prior year. The increases in deposit account service charges in these periods were primarily the result of a fee income initiative to adjust the pricing of fees, types of fees, and features of our deposit accounts, as well as growth in deposit balances. We were able to increase fees without losing customers.

Loan Referral Fees. We earn loan referral fees when we originate a variable rate loan and the borrower enters into an interest rate swap agreement with a third party to fix the interest rate for an extended period, usually 20 or 25 years. We recognize the loan referral fee for arranging the interest rate swap. By facilitating interest rate swaps to our clients, we are able to provide them with a long-term, fixed interest rate without the assuming the interest rate risk. Loan referral fees were $130,000 for the three months ended March 31, 2018, compared to no such fees in the same period in the prior year. Interest rate volatility, swap rates, and the timing of loan closings all impact the demand for long-term fixed rate swaps. The recognition of loan referral fees fluctuate in response to these market conditions and as a result we may not recognize any loan referral fees in some periods. Loan referral fees were $439,000 for the year ended December 31, 2017, an increase of $16,000, or 3.8%, over the prior year.

Mortgage Broker Fees. We earn mortgage broker fees for residential mortgage loans that we broker through Quicken Loans. Mortgage broker fees decreased $4,000 in the three months ended March 31, 2018, compared to

 

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the same period in 2017 as a result of higher mortgage interest rates and lower inventory of housing in our key markets, which decreased the demand for new mortgages. Mortgage broker fees declined $91,000 in 2017 compared to 2016 as a result of lower volume.

Gain on Sale of Loans. We typically sell in the secondary market the guaranteed portion (generally 75% of the principal balance) of the SBA and United States Department of Agriculture loans that we originate. Gain on sale of loans increased $38,000 to $64,000 in the three months ended March 31, 2018, compared to the same period in 2017 as a result of increased focus on production after restructuring our SBA loan program in 2017. Gain on sale of loans declined to $102,000 in 2017 from $790,000 in 2016 as we reduced staff and restructured our underwriting and administration of this program, while reducing our focus on originating loans for sale. In 2017, we originated $4.8 million of SBA loans, compared to $7.4 million in 2016. We intend to add one or more experienced SBA lenders and increase our origination activity in 2018.    

Other. This category includes a variety of other income-producing activities, annuity broker fees, and SBA servicing fees. Other noninterest income decreased $28,000 in the three months ended March 31, 2018, compared to the same period in 2017 as a result of lower SBA servicing revenue and lower annuity broker fees. Other noninterest income decreased $382,000, or 42.4%, in 2017 compared to 2016 due primarily to a one-time $325,000 break-up fee that was recognized in 2016 in connection with a transaction that was terminated in 2015.

Noninterest Expense

Generally, noninterest expense is composed of all employee expenses and costs associated with operating our facilities, obtaining and retaining customer relationships and providing bank services. The largest component of noninterest expense is salaries and employee benefits. Noninterest expense also includes operational expenses, such as occupancy expense, data processing expense, director and staff expense, marketing expense, and legal and professional fees.

For the three months ended March 31, 2018, noninterest expense totaled $6.1 million, an increase of $691,000, or 12.9%, compared to $5.4 million for the three months ended March 31, 2017. For the year ended December 31, 2017, noninterest expense totaled $22.4 million, an increase of $895,000, or 4.2%, compared to $21.5 million for the year ended December 31, 2016.

The following table presents, for the periods indicated, the major categories of noninterest expense:

 

     Three Months Ended
March 31,
     Increase
(Decrease)
    Percent
Change
    Year Ended
December 31,
     Increase
(Decrease)
    Percent
Change
 
(Dollars in thousands)    2018     2017          2017     2016       

Salaries and employee benefits

   $ 3,735     $ 3,282      $ 453       13.8   $ 13,383     $ 11,988      $ 1,395       11.6

Occupancy

     823       729        94       12.9       3,037       2,694        343       12.7  

Data processing

     479       401        78       19.5       1,777       1,995        (218     (10.9

Director and staff expenses

     144       141        3       2.1       561       543        18       3.3  

Excise taxes

     124       113        11       9.7       459       357        102       28.6  

Marketing

     57       67        (10     (14.9     446       437        9       2.1  

Legal and professional fees

     80       90        (10     (11.1     355       380        (25     (6.6

FDIC assessments

     85       103        (18     (17.5     331       367        (36     (9.8

Business development

     88       67        21       31.3       294       294        -       -  

OREO and repossessed assets operations, net

     (2     4        (6     N/M       (23     342        (365     N/M  

Other

     454       379        75       19.8       1,813       2,141        (328     (15.3
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

Total noninterest expense

   $ 6,067     $ 5,376      $ 691       12.9   $ 22,433     $ 21,538      $ 895       4.2
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

   

 

 

    

 

 

   

 

 

 

 

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Salaries and Employee Benefits. Salaries and employee benefits are the largest component of noninterest expense and include payroll expense, incentive compensation costs, benefit plans, health insurance and payroll taxes. Salaries and employee benefits were $3.7 million for the three months ended March 31, 2018, an increase of $453,000, or 13.8%, compared to $3.3 million for the three months ended March 31, 2017. The increase was primarily due to hiring additional staff for our Woodinville branch, which opened in October 2017, and hiring additional staff for our ongoing growth initiatives. Salaries and employee benefits were $13.4 million for the year ended December 31, 2017, an increase of $1.4 million, or 11.6%, compared to $12.0 million for the year ended December 31, 2016. The increase was primarily due to an increase in staffing to support our growth objectives, including hiring additional staff for our Woodinville branch, and to enhance our compliance infrastructure. As of March 31, 2018, we had 159 full-time equivalent employees, compared to 156 at December 31, 2017, and 142 at December 31, 2016.

Occupancy Expenses. Occupancy expenses were $823,000 for the three months ended March 31, 2018, compared to $729,000 for the three months ended March 31, 2017. Occupancy expenses were $3.0 million for the year ended December 31, 2017, compared to $2.7 million for the year ended December 31, 2016. This category includes building, leasehold, furniture, fixtures and equipment depreciation totaling $254,000 and $230,000 for the three months ended March 31, 2018 and 2017, respectively, and $993,000 and $895,000 for years ended December 31, 2017 and 2016, respectively. The increase of $94,000, or 12.9%, in occupancy expenses for the three months ended March 31, 2018, compared to the same period in the prior year was primarily due to opening our Woodinville branch in October 2017 and higher building maintenance costs. The increase of $343,000, or 12.7%, in occupancy expenses for 2017 compared to 2016 was primarily due to increased lease costs and higher building maintenance. We opened our 13th branch in Woodinville in the fall of 2017. This new branch increased our lease, depreciation, maintenance, and utility costs for 2017.

Data Processing. Data processing costs were $479,000 for the three months ended March 31, 2018, compared to $401,000 for the three months ended March 31, 2017. Data processing costs were $1.8 million for the year ended December 31, 2017, compared to $2.0 million for the year ended December 31, 2016. Data processing costs include all of our customer processing, computer processing, and network costs. In 2016, we upgraded our core customer processing system and achieved costs savings that enabled us to grow deposits, loans, and customers without increasing our data processing costs in 2017. We anticipate that our data processing costs will increase proportionately as we grow our customer base and deposits and loans.

Other. This category includes dues and subscriptions, office supplies, mail services, telephone, examination fees, internal loan expenses, services charges from banks, operational losses, directors and officers insurance, donations, provision for unfunded commitments, and miscellaneous other expenses.

Other noninterest expense increased to $454,000 for the three months ended March 31, 2018, compared to $379,000 for the three months ended March 31, 2017. The increase was primarily due to costs associated with supporting the communities we serve through memberships and sponsorships and slight increases in office supplies and losses on deposit accounts. Other noninterest expense decreased to $1.8 million for the year ended December 31, 2017, compared to $2.1 million for the year ended December 31, 2016, a decrease of $328,000, or 15.3%. The decrease was primarily due to decreased loan expenses as we benefitted from stronger credit quality, lower mail service expenses, and lower directors and officers insurance expense.

Income Tax Expense

The amount of income tax expense we incur is impacted by the amounts of our pre-tax income, tax-exempt income and other nondeductible expenses. Deferred tax assets and liabilities are reflected at current income tax rates in effect for the period in which the deferred tax assets and liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. Valuation allowances are established when necessary to reduce our deferred tax assets to the amount expected to be realized.

 

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Three Months Ended March 31, 2018, Compared to Three Months Ended March 31, 2017. For the three months ended March 31, 2018, income tax expense totaled $474,000, compared to $578,000 for the three months ended March 31, 2017. Our effective tax rates for the three months ended March 31, 2018 and 2017, were 20.5% and 30.6%, respectively. The lower tax rate in 2018 was the result of the reduction in the corporate income tax rate under the Tax Cuts and Jobs Act.

Year Ended December 31, 2017, Compared to Year Ended December 31, 2016. For the year ended December 31, 2017, income tax expense totaled $4.7 million, compared to $2.5 million for the year ended December 31, 2016. The income tax expense for 2017 included $1.3 million in additional expense that resulted from the revaluation of our deferred tax assets as a result of the reduction in the corporate income tax rate under the Tax Cuts and Jobs Act. Excluding the effect of the charge for revaluation of our deferred tax assets, our effective tax rates for the years ended December 31, 2017 and 2016, were 33.3% and 32.9%, respectively.

Financial Condition

Our total assets increased $25.2 million, or 3.1%, to $831.0 million as of March 31, 2018, from $805.8 million as of December 31, 2017. Our asset growth in the first quarter of 2018 was primarily due to $21.7 million in loan growth and a $4.8 million increase in cash and cash equivalents, offset by a decrease of $1.0 million in investment securities. Our growth was primarily funded by $24.0 million in deposit growth during the first quarter. Our total assets increased $65.2 million, or 8.8%, to $805.8 million as of December 31, 2017, from $740.6 million as of December 31, 2016. Our asset growth in 2017 was primarily due to $60.7 million in loan growth, which we funded primarily through growth in customer deposits.

Loan Portfolio

Our primary source of income is derived through interest earned on loans. A substantial portion of our loan portfolio consists of commercial and industrial loans and real estate loans secured by commercial real estate properties located in the Puget Sound region. Our loan portfolio represents the highest yielding component of our earning assets.

As of March 31, 2018, loans totaled $678.5 million, an increase of $21.7 million, or 3.3%, compared to December 31, 2017. As of December 31, 2017, loans totaled $656.8 million, an increase of $60.7 million, or 10.2%, compared to $596.1 million as of December 31, 2016. These increases were primarily due to our efforts to increase income by building a diversified loan portfolio while maintaining strong credit quality.

Loans as a percentage of deposits were 93.3% as of March 31, 2018, 93.4% as of December 31, 2017, and 91.9% as of December 31, 2016. We are focused on serving our communities and markets by growing loans and funding those loans with customer deposits.

 

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The following table summarizes our loan portfolio by type of loan as of the dates indicated:

 

     As of
March 31, 2018
    As of December 31,  
       2017     2016  
(Dollars in thousands)    Amount     Percent     Amount     Percent     Amount     Percent  

Commercial and industrial loans

   $ 86,719       12.8   $ 88,688       13.5   $ 71,397       12.0

Real estate loans:

            

Construction, land and land development

     44,970       6.6       41,641       6.3       55,565       9.3  

Residential real estate

     90,624       13.4       87,031       13.3       77,361       13.0  

Commercial real estate

     453,927       66.9       437,717       66.6       391,046       65.5  

Consumer and other loans

     2,558       0.3       2,058       0.3       1,276       0.2  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross loans

     678,798       100.0     657,135       100.0     596,645       100.0

Net deferred origination fees

     (283       (347       (517  
  

 

 

     

 

 

     

 

 

   

Loans

   $ 678,515       $ 656,788       $ 596,128    
  

 

 

     

 

 

     

 

 

   

 

     As of December 31,  
     2015     2014     2013  
(Dollars in thousands)    Amount     Percent     Amount     Percent     Amount     Percent  

Commercial and industrial loans

   $ 68,347       13.7   $ 51,088       11.8   $ 37,511       10.4

Real estate loans:

            

Construction, land and land development

     44,522       8.9       37,397       8.7       29,565       8.2  

Residential real estate

     82,750       16.5       53,925       12.5       54,140       15.0  

Commercial real estate

     302,747       60.6       286,698       66.4       236,729       65.8  

Consumer and other loans

     1,299       0.3       2,638       0.6       2,065       0.6  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross loans

     499,595       100.0     431,746       100.0     360,010       100.0

Net deferred origination fees

     (409       (627       (693  
  

 

 

     

 

 

     

 

 

   

Loans

   $ 499,186       $ 431,119       $ 359,317    
  

 

 

     

 

 

     

 

 

   

Commercial and Industrial Loans. Commercial and industrial loans are underwritten after evaluating and understanding the borrower’s ability to operate profitably and effectively. These loans are primarily made based on the borrower’s ability to service the debt from income. Most commercial and industrial loans are secured by the assets being financed or other business assets, such as accounts receivable or inventory, and generally include personal guarantees.

Commercial and industrial loans decreased $2.0 million, or 2.3%, to $86.7 million as of March 31, 2018, from $88.7 million as of December 31, 2017. The decrease was due to seasonal runoff in our loan portfolio. Commercial and industrial loans increased $17.3 million, or 24.2%, to $88.7 million as of December 31, 2017, from $71.4 million as of December 31, 2016. The increase was due, in part, to our diversification strategy, which includes sourcing loans from strong markets with good returns and risk characteristics to supplement growth in our existing markets. In 2017, we purchased $9.9 million of high-quality medical equipment loans made to doctors. The loans were individually underwritten to the Bank’s standards before being funded. We may purchase additional loans of various types in the future to support the diversification of our loan portfolio and to invest excess liquidity. We may consider additional purchases of medical equipment loans after we assess the performance of our initial purchase of these loans.

Construction, Land and Land Development Loans. Construction, land and land development loans are comprised of loans to fund construction, land acquisition and land development construction. The properties securing these loans are primarily located in the Puget Sound region and are comprised of both residential and commercial properties, including owner occupied properties and investor properties.

 

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Construction, land and land development loans increased $3.4 million, or 8.2%, to $45.0 million as of March 31, 2018, from $41.6 million as of December 31, 2017. The increase was primarily due to favorable weather conditions for building in our market area. Unfunded loan commitments for construction, land and land development loans increased to $39.2 million at March 31, 2018, from $30.8 million at December 31, 2017. Construction, land and land development loans decreased $14.0 million, or 25.2%, to $41.6 million as of December 31, 2017, from $55.6 million as of December 31, 2016, as the robust real estate market in the Puget Sound region resulted in newly constructed homes selling quickly, enabling builders to repay their loans more quickly. As of December 31, 2017, we had a number of construction loans that have been approved, primarily for residential projects, where the contractor/developer had not requested the funds, resulting in our unfunded construction and development commitments to grow to $30.8 million at December 31, 2017, from $18.9 million at December 31, 2016. Because of the strong residential real estate market in the Puget Sound region, we expect to see construction and development loans continue to pay off more quickly than we have experienced historically.

Residential Real Estate Loans. We originate one-to-four family adjustable rate mortgage loans for our own loan portfolio and as a mortgage broker for Quicken Loans. Loans that we originate as a broker are not funded by us and do not appear on our balance sheet. From time to time, we purchase residential mortgages originated by other financial institutions to hold for investment with the intent to diversify our residential mortgage loan portfolio, meet certain regulatory requirements and increase our interest income. As of March 31, 2018, purchased residential real estate loans totaled $37.9 million. We also make one-to-four family loans to investors to finance their rental properties and to business owners to secure their business loans. As of March 31, 2018, residential real estate loans made to investors and business owners totaled $34.9 million. In addition, we originate home equity lines of credit and home equity term loans for our portfolio.

Our residential loans increased $3.6 million, or 4.1%, to $90.6 million as of March 31, 2018, from $87.0 million as of December 31, 2017. Our residential loans increased $9.6 million, or 12.4%, to $87.0 million as of December 31, 2017, from $77.4 million as of December 31, 2016. The increases were primarily a result of our diversification strategy to supplement existing loan growth with purchased loans individually underwritten to our credit standards. Most of the one-to-four family loans that we purchase are from other lenders in the Puget Sound region or in California.

Commercial Real Estate Loans. We make commercial mortgage loans collateralized by owner-occupied and non-owner-occupied real estate, as well as multi-family residential loans. The real estate securing our existing commercial real estate loans includes a wide variety of property types, such as manufacturing and processing facilities, business parks, warehouses, retail centers, convenience stores and gas stations, hotels and motels, office buildings, mixed-use residential and commercial, and other properties. Commercial real estate loans represented 66.9% of our loan portfolio at March 31, 2018, and are our largest source of revenue.

Commercial real estate loans increased $16.2 million, or 3.7%, to $453.9 million as of March 31, 2018, from $437.7 million as of December 31, 2017. Commercial real estate loans increased $46.7 million, or 11.9%, to $437.7 million as of December 31, 2017, from $391.0 million as of December 31, 2016. These increases, which occurred across the various segments of our portfolio, were due to our commitment to grow this portfolio in the Puget Sound region. We actively seek commercial real estate loans in our markets and our lenders are experienced in competing for these loans.

Consumer and Other Loans. Our consumer and other loans are comprised of personal lines of credit, automobile, boat, and recreational vehicle loans, and secured term loans. Consumer and other loans increased $500,000, or 23.8%, to $2.6 million as of March 31, 2018, from $2.1 million as of December 31, 2017. Consumer and other loans increased $782,000, or 61.3%, to $2.1 million as of December 31, 2017, from $1.3 million as of December 31, 2016. The increases in these loans were primarily a result of strong consumer confidence and economic strength in the Puget Sound region.

 

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The contractual maturity ranges of loans in our loan portfolio and the amount of such loans with fixed and floating interest rates in each maturity range as of date indicated are summarized in the following tables:

 

     As of March 31, 2018  
(Dollars in thousands)    Due in One Year
or Less
     Due After One
Year Through
Five Years
     Due After Five
Years
     Gross Loans  

Commercial and industrial loans

   $ 24,099      $ 44,354      $ 18,266      $ 86,719  

Real estate loans:

           

Construction, land and land development

     31,348        11,500        2,122        44,970  

Residential real estate

     13,907        19,037        57,680        90,624  

Commercial real estate

     24,727        140,997        288,203        453,927  

Consumer and other loans

     817        1,426        315        2,558  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 94,898      $ 217,314      $ 366,586      $ 678,798  
  

 

 

    

 

 

    

 

 

    

 

 

 

 

     As of December 31, 2017  
(Dollars in thousands)    Due in One Year
or Less
     Due After One
Year Through
Five Years
     Due After Five
Years
     Gross Loans  

Commercial and industrial loans

   $ 26,863      $ 41,744      $ 20,081      $ 88,688  

Real estate loans:

           

Construction, land and land development

     33,030        7,499        1,112        41,641  

Residential real estate

     17,294        18,347        51,390        87,031  

Commercial real estate

     29,878        117,637        290,202        437,717  

Consumer and other loans

     603        1,136        319        2,058  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 107,668      $ 186,363      $ 363,104      $ 657,135  
  

 

 

    

 

 

    

 

 

    

 

 

 

The following table sets forth all loans at March 31, 2018, that are due after March 31, 2019, and have either fixed interest rates or floating or adjustable interest rates:

 

(Dollars in thousands)    Fixed Rates      Floating or
Adjustable Rates
     Total  

Commercial and industrial loans

   $ 46,757      $ 15,863      $ 62,620  

Real estate loans:

        

Construction, land and land development

     8,800        4,822        13,622  

Residential real estate

     16,222        60,495        76,717  

Commercial real estate

     172,284        256,916        429,200  

Consumer and other loans

     1,585        156        1,741  
  

 

 

    

 

 

    

 

 

 

Total

   $ 245,648      $ 338,252      $ 583,900  
  

 

 

    

 

 

    

 

 

 

The following table sets forth all loans at December 31, 2017, that are due after December 31, 2018, and have either fixed interest rates or floating or adjustable interest rates:

 

(Dollars in thousands)    Fixed
Rates
     Floating or
Adjustable Rates
     Total  

Commercial and industrial loans

   $ 45,168      $ 16,657      $ 61,825  

Real estate loans:

        

Construction, land and land development

     7,499        1,112        8,611  

Residential real estate

     16,584        53,154        69,738  

Commercial real estate

     136,273        271,566        407,839  

Consumer and other loans

     1,356        99        1,455  
  

 

 

    

 

 

    

 

 

 

Total

   $ 206,880      $ 342,588      $ 549,468  
  

 

 

    

 

 

    

 

 

 

 

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Nonperforming Assets

Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are placed on nonaccrual status when, in management’s opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by applicable regulations. Loans may be placed on nonaccrual status regardless of whether or not such loans are considered past due. In general, we place loans on nonaccrual status when they become 90 days past due. We also place loans on nonaccrual status if they are less than 90 days past due if the collection of principal or interest is in doubt. When loans are placed on nonaccrual status, all unpaid accrued interest is reversed from income and all interest accruals are stopped. Interest income is subsequently recognized only to the extent cash payments are received in excess of principal balance. Loans are returned to accrual status if we believe that all remaining principal and interest is fully collectible and there has been at least six months of sustained repayment performance since the loan was placed on nonaccrual status.

We believe our conservative lending practices and active approach to managing nonperforming assets has resulted in sound asset quality and timely resolution of problem assets. We have several procedures in place to assist us in maintaining the overall credit quality of our loan portfolio. We have established underwriting guidelines, and we also monitor our delinquency levels for any negative or adverse trends. We actively manage problem assets to reduce our risk for loss.

We had $1.7 million in nonperforming assets, including performing troubled debt restructurings, or TDRs, as of March 31, 2018, compared to $2.1 million as of December 31, 2017, and we had $1.7 million in nonperforming loans as of March 31, 2018, compared to $2.1 million as of December 31, 2017. The decrease in nonperforming assets was the result of a decline in nonperforming commercial real estate loans. We had $2.1 million in nonperforming assets, including performing TDRs, as of December 31, 2017, compared to $8.2 million as of December 31, 2016, and we had $2.1 million in nonperforming loans as of December 31, 2017, compared to $1.6 million as of December 31, 2016. The decrease in nonperforming assets was the result of the sale of our remaining real estate owned property and the payoff of our remaining TDRs in 2017.

 

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The following table presents information regarding nonperforming assets at the dates indicated:

 

     As of
March 31,
2018
    As of December 31,  
(Dollars in thousands)      2017     2016     2015     2014     2013  

Non-accrual loans:

            

Commercial and industrial loans

   $ 396     $ 372     $ 28     $ 1,297     $ 59     $ 7  

Real estate loans:

            

Construction, land and land development

     -       -       -       -       -       46  

Residential real estate

     88       88       98       -       -       133  

Commercial real estate

     1,303       1,660       1,363       1,409       1,462       2,418  

Consumer and other loans

     -       -       -       -       -       -  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total non-accrual loans

     1,699       2,120       1,489       2,706       1,521       2,604  

Accruing loans past due 90 days or more:

            

Commercial and industrial loans

     -       -       -       -       -       -  

Real estate loans:

            

Construction, land and land development

     -       -       122       -       -       -  

Residential real estate

     -       -       -       -       -       -  

Commercial real estate

     -       -       -       -       -       -  

Consumer and other loans

     -       -       -       -       -       -  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total accruing loans past due 90 days or more

     -       -       122       -       -       -  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total nonperforming loans

     1,699       2,120       1,611       2,706       1,521       2,604  

Real estate owned

     -       -       1,297       1,231       3,059       1,903  

Repossessed assets

     -       -       -       100       350       790  

Troubled debt restructurings, accruing

     -       -       5,326       5,416       5,467       -  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total nonperforming assets

   $ 1,699     $ 2,120     $ 8,234     $ 9,453     $ 10,397     $ 5,297  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total nonperforming loans to total loans

     0.25     0.32     0.27     0.54     0.35     0.72

Total nonperforming assets to total assets

     0.20     0.26     1.11     1.52     1.90     1.24
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Potential Problem Loans

From a credit risk standpoint, we classify loans in one of five categories: pass, other loans especially mentioned, substandard, doubtful or loss. Within the pass category, we classify loans into one of the following five subcategories based on perceived credit risk, including repayment capacity and collateral security: minimal risk; low risk; modest risk; average risk; and acceptable risk. The classifications of loans reflect a judgment about the risks of default and loss given default. We review the risk ratings of our credits on an annual basis, or more frequently if circumstances warrant. Risk ratings are adjusted to reflect the degree of risk and loss that is believed to be inherent in each credit as of each monthly reporting period. Our methodology is structured so that specific reserve allocations are increased in accordance with deterioration in credit quality (and a corresponding increase in risk and loss) or decreased in accordance with improvement in credit quality (and a corresponding decrease in risk and loss).

Credits rated other loans especially mentioned show clear signs of financial weaknesses or deterioration in creditworthiness; however, such concerns are not so pronounced that we generally expect to experience significant loss within the short-term. Such credits typically maintain the ability to perform within standard credit terms and credit exposure is not as prominent as credits with a lower rating.

Credits rated substandard are those in which the normal repayment of principal and interest may be, or has been, jeopardized by reason of adverse trends or developments of a financial, managerial, economic or political

 

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nature, or important weaknesses in the collateral for the loan. A protracted workout on these credits is a distinct possibility. Prompt corrective action is therefore required to reduce exposure and to assure that adequate remedial measures are taken by the borrower. Credit exposure becomes more likely in such credits and a serious evaluation of the secondary support to the credit is performed.

Credits rated as doubtful have weaknesses of substandard assets that are sufficient to make collection or liquidation in full questionable and there is a high probability of loss based on currently existing facts, conditions and values.

Credits rated as loss are charged-off. We have no expectation of the recovery of any payments in respect of credits rated as loss.

The following table summarizes the internal ratings of our loans as of the dates indicated:

 

     As of March 31, 2018  
(Dollars in thousands)    Pass      Other Loans
Especially
Mentioned
     Substandard      Doubtful      Total  

Commercial and industrial loans

   $ 85,194      $ 392      $ 1,133      $ -      $ 86,719  

Real estate loans:

              

Construction, land and land development

     42,417        2,553        -        -        44,970  

Residential real estate

     90,146        126        352        -        90,624  

Commercial real estate

     450,316        2,308        1,303        -        453,927  

Consumer and other loans

     2,558        -        -        -        2,558  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 670,631      $ 5,379      $ 2,788      $ -      $ 678,798  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 
     As of December 31, 2017  
(Dollars in thousands)    Pass      Other Loans
Especially
Mentioned
     Substandard      Doubtful      Total  

Commercial and industrial loans

   $ 87,247      $ 376      $ 902      $ 163      $ 88,688  

Real estate loans:

              

Construction, land and land development

     39,081        2,560        -        -        41,641  

Residential real estate

     86,464        479        88        -        87,031  

Commercial real estate

     434,421        1,636        1,315        345        437,717  

Consumer and other loans

     2,058        -        -        -        2,058  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 649,271      $ 5,051      $ 2,305      $ 508      $ 657,135  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 
     As of December 31, 2016  
(Dollars in thousands)    Pass      Other Loans
Especially
Mentioned
     Substandard      Doubtful      Total  

Commercial and industrial loans

   $ 68,606      $ 1,890      $ 901        -      $ 71,397  

Real estate loans:

              

Construction, land and land development

     54,324        1,119        122        -        55,565  

Residential real estate

     77,057        -        304        -        77,361  

Commercial real estate

     384,892        811        5,343        -        391,046  

Consumer and other loans

     1,276        -        -        -        1,276  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 586,155      $ 3,820      $ 6,670        -      $ 596,645  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

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Allowance for Loan Losses

We maintain an allowance for loan losses that represents management’s best estimate of the loan losses and risks inherent in our loan portfolio. The amount of the allowance for loan losses should not be interpreted as an indication that charge-offs in future periods will necessarily occur in those amounts. In determining the allowance for loan losses, we estimate losses on specific loans, or groups of loans, where the probable loss can be identified and reasonably determined. The balance of the allowance for loan losses is based on internally assigned risk classifications of loans, historical loan loss rates, changes in the nature of our loan portfolio, overall portfolio quality, industry concentrations, delinquency trends, and current economic factors. See “—Critical Accounting Policies—Allowance for Loan Losses.”

In connection with the review of our loan portfolio, we consider risk elements applicable to particular loan types or categories in assessing the quality of individual loans. Some of the risk elements we consider include:

 

    for commercial and industrial loans, the debt service coverage ratio (income from the business in excess of operating expenses compared to loan repayment requirements), the operating results of the commercial, professional or agricultural enterprise, the borrower’s business, professional and financial ability and expertise, the specific risks and volatility of income and operating results typical for businesses in that category and the value, nature and marketability of collateral;

 

    for commercial real estate loans, the debt service coverage ratio, operating results of the owner in the case of owner-occupied properties, the loan-to-value ratio, the age and condition of the collateral and the volatility of income, property value and future operating results typical of properties of that type;

 

    for residential mortgage loans, the borrower’s ability to repay the loan, including a consideration of the debt-to-income ratio and employment and income stability, the loan-to-value ratio, and the age, condition and marketability of the collateral; and

 

    for construction, land and land development loans, the perceived feasibility of the project including the ability to sell developed lots or improvements constructed for resale or the ability to lease property constructed for lease, the quality and nature of contracts for presale or prelease, if any, experience and ability of the developer and loan-to-value ratio.

As of March 31, 2018, the allowance for loan losses totaled $8.4 million, or 1.24% of total loans. Our allowance for loan losses as of March 31, 2018, increased by $406,000, or 5.1%, compared to December 31, 2017, primarily due to growth in our loan portfolio. As of December 31, 2017, the allowance for loan losses totaled $8.0 million, or 1.22% of total loans. Our allowance for loan losses as of December 31, 2017, increased by $473,000, or 6.3%, compared to December 31, 2016, primarily due to the organic growth of our loan portfolio.

 

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The following tables present, as of and for the periods indicated, an analysis of the allowance for loan losses and other related data:

 

     As of or
for the
Three
Months
Ended
March 31,
2018
   

 

As of or for the Year Ended December 31,

 
(Dollars in thousands)      2017     2016     2015     2014     2013  

Allowance at beginning of period

   $ 8,017     $ 7,544     $ 5,989     $ 5,557     $ 4,268     $ 3,845  

Provision for loan losses

     501       870       1,919       941       1,690       1,493  

Charge-offs:

            

Commercial and industrial loans

     9       81       128       637       -       100  

Real estate loans:

            

Construction, land and land development

     -       -       -       -       15       -  

Residential real estate

     -       -       79       25       280       881  

Commercial real estate

     84       408       150       -       200       293  

Consumer and other loans

     5       11       10       3       3       144  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total charge-offs

     98       500       367       665       498       1,318  

Recoveries:

            

Commercial and industrial loans

     1       3       2       7       -       -  

Real estate loans:

            

Construction, land and land development loans

     -       95       -       -       15       -  

Residential real estate

     -       -       -       141       77       244  

Commercial real estate

     -       -       -       8       -       -  

Consumer and other loans

     2       5       1       -       5       4  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total recoveries

     3       103       3       156       97       248  

Net charge-offs

     (95     (397     (364     (509     (401     (1,070
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Allowance at end of period

   $ 8,423     $ 8,017     $ 7,544     $ 5,989     $ 5,557     $ 4,268  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Allowance to nonperforming loans

     495.76     378.16     468.28     221.32     365.35     163.90

Allowance to total loans

     1.24     1.22     1.27     1.20     1.29     1.19

Net charge-offs to average loans (1)

     0.06     0.06     0.07     0.11     0.10     0.33
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Ratio for the three months ended March 31, 2018, is annualized.

Although we believe that we have established our allowance for loan losses in accordance with GAAP and that the allowance for loan losses was adequate to provide for known and inherent losses in the portfolio at all times shown above, future provisions for loan losses will be subject to ongoing evaluations of the risks in our loan portfolio. If the Puget Sound region experiences an economic downturn, our asset quality could deteriorate or if we are successful in continuing to grow our loan portfolio, our allowance may become inadequate and material additional provisions for loan losses could be necessary.

 

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The following table shows the allocation of the allowance for loan losses among loan categories and certain other information as of the dates indicated. The allocation of the allowance for loan losses as shown in the table should neither be interpreted as an indication of future charge-offs, nor as an indication that charge-offs in future periods will necessarily occur in these amounts or in the indicated proportions. The total allowance is available to absorb losses from any loan category.

 

     As of
March 31, 2018
    As of December 31,  
       2017     2016  
(Dollars in thousands)    Allowance
Allocated to
Loan Portfolio
     Loan Category
as a % of Total
Loans
    Allowance
Allocated to
Loan Portfolio
     Loan Category
as a % of Total
Loans
    Allowance
Allocated to
Loan Portfolio
     Loan Category
as a % of Total
Loans
 

Commercial and industrial loans

   $ 2,028        12.8   $ 1,864        13.5   $ 1,606        12.0

Real estate loans:

               

Construction, land and land development

     1,133        6.6       1,063        6.3       1,398        9.3  

Residential real estate

     1,328        13.4       1,343        13.2       1,495        13.0  

Commercial real estate

     2,088        66.9       2,014        66.6       1,474        65.5  

Consumer and other loans

     53        0.3       43        0.4       26        0.2  

Unallocated

     1,793        n/a       1,690        n/a       1,545        n/a  
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total allowance for loan losses

   $ 8,423        100.0   $ 8,017        100.0   $ 7,544        100.0
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

 

     As of December 31,  
     2015     2014     2013  
(Dollars in thousands)    Allowance
Allocated to
Loan Portfolio
     Loan Category
as a % of Total
Loans
    Allowance
Allocated to
Loan Portfolio
     Loan Category
as a % of Total
Loans
    Allowance
Allocated to
Loan Portfolio
     Loan Category
as a % of Total
Loans
 

Commercial and industrial loans

   $ 1,311        13.7   $ 1,028        11.8   $ 391        10.4

Real estate loans:

               

Construction, land and land development

     1,031        8.9       1,231        8.7       299        8.2  

Residential real estate

     1,744        16.5       925        12.5       616        15.0  

Commercial real estate

     1,509        60.6       2,107        66.4       2,744        65.8  

Consumer and other loans

     35        0.3       39        0.6       18        0.6  

Unallocated

     359        n/a       227        n/a       200        n/a  
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total allowance for loan losses

   $ 5,989        100.0   $ 5,557        100.0   $ 4,268        100.0
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Securities

We use our securities portfolio primarily as a source of liquidity and collateral that can be readily sold or pledge for public deposits or other business purposes. At March 31, 2018, 87.3% of our investment portfolio consisted of U.S. Treasury securities. The remainder of our securities portfolio was invested in U.S. Government

 

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agency securities, agency collateralized mortgage obligations and mortgage-backed securities, and municipal bonds. Because we target a loan-to-deposit ratio in the range of 90% to 100%, we prioritize liquidity over the earnings of our securities portfolio. At March 31, 2018, our loan-to-deposit ratio was 93.3% and our securities portfolio represented less than 5% of assets. To the extent our securities represent more than 5% of assets, absent an immediate need for liquidity, we anticipate investing excess funds to provide a higher return.

As of March 31, 2018, the carrying amount of our investment securities totaled $37.3 million, a decrease of $1.0 million, or 2.6%, compared to $38.3 million as of December 31, 2017. The decrease in the securities portfolio was primarily the result of the decline in fair value and pay-downs on mortgage-backed securities. As of December 31, 2017, the carrying amount of our investment securities totaled $38.3 million, an increase of $3.3 million, or 9.4%, compared to $35.0 million as of December 31, 2016. The increase in the securities portfolio was due primarily to the investment of excess cash and cash equivalent balances. Investment securities represented 4.8% and 4.7% of total assets as of December 31, 2017 and 2016, respectively.

Our investment portfolio consists of securities classified as available for sale and, to a lesser amount, held to maturity. The carrying values of our investment securities classified as available for sale are adjusted for unrealized gain or loss, and any gain or loss is reported on an after-tax basis as a component of other comprehensive income in shareholders’ equity.

The following table summarizes the amortized cost and estimated fair value of our investment securities as of the dates shown:

 

    As of
March 31, 2018
    As of December 31,  
      2017     2016     2015  
(Dollars in thousands)   Amortized
Cost
    Fair
Value
    Amortized
Cost
    Fair
Value
    Amortized
Cost
    Fair
Value
    Amortized
Cost
    Fair
Value
 

Securities available-for-sale:

               

U.S. Treasury securities

  $ 34,803     $ 32,550     $ 34,794     $ 33,396     $ 29,746     $ 28,248     $ 5,991     $ 5,986  

U.S. government securities

    3,000       2,948       3,000       2,970       4,000       3,961       7,001       6,976  

U.S. Agency collateralized mortgage obligations

    215       210       224       221       290       289       382       380  

U.S. Agency residential mortgage-backed securities

    50       51       79       80       119       121       159       162  

Municipal bonds

    261       257       261       260       490       487       495       496  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total available-for-sale securities

    38,329       36,016       38,358       36,927       34,645       33,106       14,028       14,000  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Securities held-to-maturity:

               

U.S. Agency residential mortgage-backed securities

    1,323       1,256       1,409       1,374       1,888       1,816       2,150       2,076  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total held-to-maturity securities

    1,323       1,256       1,409       1,374       1,888       1,816       2,150       2,076  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total investment securities

  $ 39,652     $ 37,272     $ 39,767     $ 38,301     $ 36,533     $ 34,922     $ 16,178     $ 16,076  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

All of our mortgage-backed securities and collateralized mortgage obligations are U.S. Government agency securities. As of March 31, 2018, we did not hold any Fannie Mae or Freddie Mac preferred stock, corporate equity, collateralized debt obligations, collateralized loan obligations, structured investment vehicles, private label collateralized mortgage obligations, subprime, Alt-A or second lien elements in our investment portfolio.

Our management evaluates securities for other-than-temporary impairment on at least a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation.

 

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As of March 31, 2018, and December 31, 2017 and 2016, we did not own securities of any one issuer, other than the U.S. Government and its agencies, for which aggregate adjusted cost exceeded 10.0% of consolidated shareholders’ equity.

The following table sets forth the amortized cost of held to maturity securities and the fair value of available for sale securities, maturities and approximated weighted average yield based on estimated annual income divided by the average amortized cost of our securities portfolio as of the dates indicated. The contractual maturity of a mortgage-backed security is the date at which the last underlying mortgage matures.

 

    As of March 31, 2018  
(Dollars in thousands)   One Year or Less     More than One
Year to Five Years
    More than Five
Years to Ten Years
    More than Ten
Years
    Total  
  Carrying
Value
    Weighted
Average

Yield
    Carrying
Value
    Weighted
Average

Yield
    Carrying
Value
    Weighted
Average

Yield
    Carrying
Value
    Weighted
Average

Yield
    Carrying
Value
    Weighted
Average

Yield
 
                   

Securities available-for-sale:

                   

U.S. Treasury securities

    -       -     $ 4,995       1.15   $ 29,809       1.58     -       -     $ 34,803       1.52

U.S. Government securities

    -       -       3,000       1.50       -       -       -       -       3,000       1.50  

U.S. Agency collateralized mortgage obligations

    -       -       -       -       -       -       215       2.93     215       2.93  

U.S. Agency residential mortgage-backed securities

    -       -       -       -       50       1.72       -       -       50       1.72  

Municipal bonds

    -       -       -       -       261       2.05       -       -       261       2.05  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total available-for-sale

    -       -       7,995       1.28       30,120       1.59       215       2.93       38,329       1.53  

Securities held to maturity:

                   

U.S. Agency residential mortgage-backed securities

    -       -       -       -       -       -       1,323       2.23       1,323       2.23  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total held to maturity

    -       -       -       -       -       -       1,323       2.23       1,323       2.23  

Total investment securities

    -       -     $ 7,995       1.28   $ 30,120       1.59   $ 1,538       2.33   $ 39,652       1.55
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

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Table of Contents
    As of December 31, 2017  

(Dollars in thousands)
  One Year or Less     More than One
Year to Five Years
    More than Five
Years to Ten Years
    More than Ten
Years
    Total  
  Carrying
Value
    Weighted
Average

Yield
    Carrying
Value
    Weighted
Average

Yield
    Carrying
Value
    Weighted
Average

Yield
    Carrying
Value
    Weighted
Average

Yield
    Carrying
Value
    Weighted
Average

Yield
 
                   

Securities available-for-sale:

                   

U.S. Treasury securities

    -       -     $ 4,995       1.15   $ 29,799       1.58     -       -     $ 34,794       1.52

U.S. Government securities

    -       -       3,000       1.50       -       -       -       -       3,000       1.50  

U.S. Agency collateralized mortgage obligations

    -       -       -       -       -       -       224       2.11     224       2.11  

U.S. Agency residential mortgage-backed securities

    -       -       -       -       79       3.77       -       -       79       3.77  

Municipal bonds

    -       -       -       -       261       2.05       -       -       261       2.05  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total available-for-sale

    -       -       7,995       1.28       30,139       1.59       224       2.11       38,358       1.53  

Securities held to maturity:

                   

U.S. Agency residential mortgage-backed securities

    -       -       -       -       -       -       1,409       1.76       1,409       1.76  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total held to maturity

    -       -       -       -       -       -       1,409       1.76       1,409       1.76  

Total investment securities

    -       -     $ 7,995       1.28   $ 30,139       1.59   $ 1,633       1.81   $ 39,767       1.54
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Deposits

We offer a variety of deposit products that have a wide range of interest rates and terms, including demand, savings, money market and time accounts. We rely primarily on competitive pricing policies, convenient locations, electronic delivery channels, and personalized service to attract and retain these deposits.

Total deposits as of March 31, 2018, were $727.3 million, an increase of $24.0 million, or 3.4%, compared to $703.3 million as of December 31, 2017. Total deposits as of December 31, 2017, were $703.3 million, an increase of $54.6 million, or 8.4%, compared to $648.7 million as of December 31, 2016. The increases were primarily related to our successful execution of our strategy of deepening relationships with existing customers and actively seeking new customers.

Noninterest-bearing deposits as of March 31, 2018, were $254.0 million, an increase of $11.6 million, or 4.8%, compared to $242.4 million as of December 31, 2017. Noninterest-bearing deposits as of December 31, 2017, were $242.4 million, an increase of $18.4 million, or 8.2%, compared to $224.0 million as of December 31, 2016. The increases were due to the collaboration of our branch managers, business development offices and lenders to grow core deposits. As a team, we actively pursue the business of new customers.

Total interest-bearing account balances as of March 31, 2018, were $383.8 million, an increase of $13.5 million, or 3.6% from $370.3 million as of December 31, 2017. Total interest-bearing account balances as of December 31, 2017, were $370.3 million, an increase of $22.7 million, or 6.5% from $347.6 million as of December 31, 2016. The increases were due to our team focusing on growing core deposits.

 

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Total time deposit balances as of March 31, 2018, were $89.5 million, a decrease of $1.1 million, or 1.2%, from $90.6 million as of December 31, 2017. The decrease in total deposits during the period was primarily a result of a more conservative pricing strategy during the quarter and reduced promotion of time deposits. Total time deposit balances as of December 31, 2017, were $90.6 million, an increase of $13.5 million, or 17.5%, from $77.1 million as of December 31, 2016.

The following table sets forth deposit balances at the dates indicated.

 

    As of
March 31, 2018
    As of December 31,  
      2017     2016     2015  
(Dollars in thousands)   Amount     Percent of
Total
Deposits
    Amount     Percent of
Total
Deposits
    Amount     Percent of
Total
Deposits
    Amount     Percent of
Total
Deposits